Julio Escolano

International Trade Taxes

Julio Escolano

  • Which are the arguments for and against tariffs?

  • Are tariff rates a good measure of the degree of protection?

  • What is better, a single rate or a multiple rate tariff?

  • How can exporters be insulated from the increase in their costs caused by tariffs?

  • Is there any reason to tax exports?

The last two decades have witnessed many instances of successful growth strategies in developing countries. All of them involved the implementation of outward-oriented trade strategies—lowering trade barriers, removing disincentives to exports, and implementing currency convertibility. Among developing countries, those that adopted strongly outward-oriented trade policies showed consistently better economic performance than those whose policies were inward oriented or only moderately outward oriented.1 In 1974—92, developing countries with strongly outward-oriented trade policies experienced, on average, an annual real per capita GDP growth of 6 percent and an increase in factor productivity of more than 3 percent. In contrast, the set of all developing countries experienced, on average, 1.6 percent real per capita GDP growth and about 1 percent factor productivity growth.

In the industrialized world, notwithstanding the success of outward-oriented trade strategies implemented by many developing and industrial countries, the 1970s and 1980s have also witnessed increasingly negative attitudes toward free trade. The dismantlement of trade barriers among industrial countries fostered unprecedented global economic growth in the postwar period. In contrast, the slowdown in growth and productivity, the re-emergence of large external imbalances, and higher levels of unemployment have been accompanied—and deepened—-by heightened protectionist pressures. Although tariffs have remained low in industrial countries,2 other nontariff barriers have gained importance since the mid-seventies. These barriers include, inter alia, quotas, antidumping and countervailing measures, competitive subsidization of agriculture, and “voluntary” export restraints.

In this context, the renewed interest in the theory of international trade and the wealth of new and old arguments introduced in recent years is not surprising. While the new theories of economic growth have tended to highlight the positive role of trade in fostering innovation, competition, and productivity, the theories of managed trade and strategic trade have been, to some extent, supportive of the new protectionist policies. This chapter concentrates on the fiscal dimensions of international trade taxes without attempting an exhaustive coverage of the wider field of trade policy.3

Free Trade and Protectionism

The Case for Free Trade

The traditional argument in favor of free trade goes back to the origins of economic science and to the ideas of Adam Smith and David Ricardo. International trade can be considered just another transformation activity available to the national economy: exports are transformed into imports according to their international relative prices. From the viewpoint of the consumers, international trade expands the set of goods and services that they can afford, either by reducing their price, or by making new commodities available, or by a combination of both. From the viewpoint of efficiency in production, free trade allows and encourages specialization in activities and technologies in which the country possesses a comparative advantage. The product of these activities can then be traded for those commodities for which domestic production is relatively inefficient. Thus, free trade allows a better allocation of resources with the corollary that welfare is enhanced. It is worth noting that a country will achieve a higher welfare with free trade than with protection, even if its trade partners engage in protectionist policies. This classical argument in favor of free trade is based on the same foundations as the case for market allocation of resources and against government intervention in the price setting process—import tariffs and protectionist practices are just a particular case of price distortions and restrictions to trade. Like the argument for free markets, it remains at the core of mainstream economic theory and has undergone many refinements.4

Many economists, however, believe that the classical argument for free trade does not capture some of the main gains that a country can obtain from free trade policies. Conventional arguments for free trade are static in nature while there is a widespread belief that international trade and economic growth are closely related. The new theories of economic growth seek to identify those policies and mixeds of the economic environment which are key to achieve, not only a more efficient use of existing resources, but a higher rate of output growth in the long run. In the traditional theory of growth, the removal of inefficient policies, such as barriers to trade, could prompt a one-time upward shift in the level of output but could not affect its long-term growth rate. In contrast, recent growth theory shows how free trade can significantly contribute to increase permanently the growth rate of an economy.5

Recent analytical and empirical developments have identified a variety of sources of economic growth. The main emphasis has been in the role of human capital accumulation, learning by doing, investment in re-search and development, and expansion of the span of available products. These factors have the potential to enhance the use of available resources, such as labor and nonhuman capital, reversing the tendency toward diminishing marginal returns. Moreover, some of these newly analyzed factors seem to exhibit positive externalities which produce increasing returns to scale at the macroeconomic level.6

Open trade policies allow individual countries to profit from growth enhancing factors. Imports of inter-mediate products may embody advanced technology and are the result of human capital accumulation and research and development investments realized elsewhere. Closer economic links increase the transmission of new technologies. Expanded competition forces domestic firms to accelerate the pace of absorption of new technologies and devote adequate resources to develop new or improved products. Access to world markets permits a wider diversification of output as well as a larger span of available inputs.

Protectionist policies also implicitly hamper exports. An increase in import tariffs can result in an exchange rate appreciation. The preferential treatment they afford to import-substituting industries reallocates resources toward production for the protected domestic market and away from export-oriented industries. Also, an important part of the bias against exports takes the form of general increases in costs and low productivity of factors.

Arguments in favor of protectionist policies generally assume an unrealistically enlightened government that will be able to choose the right industries to protect and that will manage trade and domestic policies in an optimal manner over time. In practice, governments have not been very successful in “picking winners”—determining which industries to support—because this depends on details of production technology and market structure which governments typically know little about.7 Trade policies often get heavily influenced by special-interest politics rather than consideration of national costs and benefits. Even when initially based on sound economic theory, protectionist policies create powerful special-interest groups that tend to perpetuate and extend privileged situations. Sophisticated programs of trade intervention and selective tariffs, even when based on technically solvent arguments, will probably be captured by interest groups and transformed into instruments of income redistribution in their favor. Beneficiaries and would-be beneficiaries of protectionist trade policies are likely to devote a potentially large amount of resources to “rent seeking”—activities aimed to maintain and extend existing protection, influence the allotment of import quotas, etc.—further magnifying distortions and inefficiencies in the domestic allocation of resources. In this context, an easy-to-monitor commitment to free trade may be the optimal viable policy.

Revenue Generation: A Nonprotectionist Case for Tariffs

The rationale for tariffs is sometimes unrelated to protectionist trade policies. Unlike nontariff barriers—quotas, competitive subsidization, voluntary export restraints, etc.—import or export tariffs yield tax revenue to the government. In some countries, taxes on international trade constitute the main and most stable source of government revenue. The need to raise revenue may outweigh, in some cases, the negative effect that tariffs have owing to their protectionist side effects.

Trade taxes are not optimal instruments to raise revenue. It can be shown that a combination of domestic taxes levied neutrally with respect to domestic and foreign products and that yield the same revenue can cause a lower efficiency loss.8 When the revenue objective is taken as given, the necessary taxes should be designed to minimize losses in efficiency and growth potential. The efficiency losses generated by taxes on international trade stem from the “wedge” they introduce between international and domestic prices. The inward-oriented bias they cause can produce large inefficiencies and seriously hamper growth. Domestic taxation such as consumption or income taxes can meet the revenue target with lower rates, broader bases, and without a protectionist bias. Taxes on domestic consumption can also be collected on imports at the border. This will fulfill the revenue function of a tariff and be equally easy to administer without protecting domestic producers. Similarly, taxes on luxury items are better designed as domestic excises—collected at the border when applied to imports—than as tariffs.

The argument against tariffs as revenue-raising instruments, however, rests on the availability of trade-neutral domestic taxation. In some cases, either the necessary domestic taxes do not exist and need an implementation period or they cannot be raised beyond existing levels. An argument in favor of trade taxes is their lower administrative cost. The World Development Report9 estimates that the administrative costs of levying trade taxes are between 1 percent and 3 percent of revenue collected. The corresponding costs for VAT and income taxes are estimated at 5 percent and 10 percent, respectively. Therefore, countries which are constrained by the weakness of their tax administration, the immature stage of market institutions, and the lack of qualified personnel and accounting sophistication of taxpayers resort to tariffs as a relatively straightforward method to raise revenue. Thus, budgetary pressures combined with exceptionally limited tax handles can dictate the use of trade taxes for revenue purposes.

In the medium- and long-term, a strategy aiming at sustainable growth should encompass the use of domestic tax instruments and implementation of administration improvements necessary to phase out any reliance on taxes on international transactions. While administrative costs of collecting trade taxes are low, the economic social cost of increasing trade taxes is generally higher than that of raising domestic taxes.10 Correspondingly, when tariffs are used with a revenue objective, the rate should be low enough to avoid any significant protectionist bias.

Balance of Payments Objectives

Tariffs or across-the-board import surcharges are often applied for balance of payments reasons by countries facing an imbalance in the external sector. An external imbalance indicates that the real exchange rate (the ratio between the domestic and foreign prices of tradable commodities) is not sustainable. It can be caused by differentials in inflation rates that are not reflected in the exchange rate, deterioration in the terms of trade, etc. By imposing a tariff, governments may try to avoid the necessary domestic adjustment.

Under a floating exchange rate regime, the tariff will prompt a revaluation offsetting the trade effect of the tariff increase. Due to that, tariffs are used to correct external imbalances under fixed exchange rate regimes or when the government tries to avoid a devaluation. The aim is to imitate the effect that a devaluation would have on the trade balance. While a devaluation would have beneficial effects on exports, however, a tariff impairs exports through increases in costs. Since resources will move away from the export sector, the measure can, in fact, worsen the trade balance in the long run.

When a country faces a balance of payments problem, the optimal response depends on the cause of the imbalance. Generally, a policy of domestic adjustment, including fiscal measures, that addresses the root of the imbalance, is necessary.

Antidumping and Countervailing Duties

Under GATT rules, antidumping and countervailing duties can be imposed by country members to protect their domestic producers from injury owing to “dumping” of goods by foreign suppliers or to offset trade-distorting subsidies set by trade partners. The legitimacy of these measures is based on the defense of competition and fair trade. Nevertheless, the imposition of duties is not always the optimal response by the importing country. Moreover, the general consensus among trade economists is that, in most cases, countries have used antidumping and countervailing provisions to implement protectionist policies.11

From the perspective of the importing country, dumping may be harmful if it involves predatory pricing or intermittent dumping. Predatory pricing occurs when prices are set below cost by foreign exporters with the objective of driving domestic firms out of business. Once domestic competition is eliminated, prices are set at monopoly levels. In practice, this type of operation is very uncommon because the preconditions for its success are rarely met. Foreign suppliers must have a stable monopolistic position on the international market and domestic suppliers must face substantial re-entry barriers. Intermittent dumping is the disposal of occasional surpluses by exporting them at exceptionally low prices. In either case, before the introduction of antidumping duties, the potential harm to competing domestic producers needs to be weighed by the government of the importing country against the eventual benefits to consumers and importers.

In many cases, legitimate market behavior is labeled as dumping by importing countries and antidumping measures are undertaken with protectionist objectives. For example, price differentials between domestic and export markets do not necessarily imply dumping behavior. Price differentiation is a profit maximizing strategy routinely implemented by firms that operate in several markets. Many actions that would not be considered unfair practices domestically are, however, prosecuted with alacrity when pursued by foreign exporters.

Countervailing duties are introduced with the objective of offsetting export subsidies implemented in the exporting country. Subsidies to “strategic” industries have been justified by proponents of the new trade theory as means to gain competitive advantage in these industries.12 Under GATT rules, subsidies are allowed on exports of primary products only. In practice, however, the subsidy component of the price of imported commodities is difficult to determine.

The incidence of antidumping and countervailing actions—including duties, voluntary export restraints, etc.—increased substantially in the late 1970s. Finger and Nogues13 report that between 1980 and 1985, the European Community and seven other countries initiated 1,155 antidumping cases and 425 antisubsidy cases. Table V.1 shows a preponderance of countervailing actions in the United States while antidumping cases are evenly spread among all countries. Bhagwati14 argues that antidumping and countervailing provisions have been “captured” by protectionist special-interest groups and domestic producers.15 The design of these provisions facilitates their use for the purpose of putting obstacles to successful foreign suppliers. Often, most of the burden of proof lies with the defendant and different forms of restrictions might be triggered at the moment of filing the complaint, independently of whether it is eventually substantiated. Kelly and McGuirk16 present evidence of the widespread use of countervailing and antidumping duties in the European Community to protect cartelized domestic markets from foreign competition—for example, in 52 percent of the cases under anticartel investigation in the chemical industry, a parallel anti-dumping action had been initiated. Once antidumping or countervailing duties are established, they tend to become permanent.

Table V.1.

Countervailing Duties and Antidumping Actions Initiated

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Source: Bhagwati (1988).

Countervailing duties and antidumping actions correspond to U.S. Trade Act, Sections 701 and 731, respectively.

The “Infant Industry” Argument

Many departures from free trade, including the import substitution policies followed by many developing countries in the 1960s and 1970s, have been justified by using different variants of this theory. The argument essentially posits that some industries have initially high costs but may, in the long run, acquire a comparative advantage after a temporary period of development. Several conditions have to be assumed for the argument to be valid:

(1) The present value of future social and private returns generated by the infant industry must be higher than that of other industries or alternative uses of resources. The cost of the infant industry should include the loss in efficiency and damage to other sectors owing to distortions caused by protection.

(2) In the absence of protection, private investment in the industry would not occur. That is, expected private returns do not justify investment in the industry. Therefore, a substantial part of the returns or decrease in costs to be generated by the industry must consist of externalities. If future benefits could be privately appropriated by the initial investors, private firms would themselves be willing to incur the initial costs and protection would be redundant. If private investors are willing to undertake the initial investment but they lack the necessary capital, other measures would be more effective than protection (e.g., liberalization of capital markets and foreign investment).

(3) Temporary protection must make initial investment in the industry cost effective for private investors. It might be the case that, even with protection, private investment does not take place. In practice, “import substitution” policies have necessitated many other government interventions besides protection—subsidies, regulation, official prices, etc. When externalities are the reason for protection, sufficient externalities must accrue to the industry itself, to become competitive eventually. If most externalities are spillovers to other industries, the infant will never be able to stand alone.

(4) The protection has to be, in fact, temporary, and must be decreased over time in an optimal manner. In particular, international competition has to be kept constantly at a sufficiently high level to encourage the cost-saving investments that will eventually render protection unnecessary. Policymakers must be able to monitor the evolution of production and market characteristics in the industry. The timetable of protection disarmament has to be well known, credibly announced, and timely implemented. If firms expect the period of protection to be extended, they will not invest in reducing costs and the industry will not be able to survive international competition. Since this is likely to force the government to extend the period of prothe expectation will become self-fulfilling.17 It is also assumed that vested interests to maintain protection will not arise or will be effectively resisted.

Thus, the validity of the infant industry argument rests on the validity of very restrictive conditions. Even when those conditions are met, free trade combined with targeted industrial policies is usually a superior response. When the cause of the externality can be clearly identified (and it is difficult to make a consistent case for protection when it cannot), a targeted policy is generally superior to across-the-board protection of the industry. For example, if intensive research and development need to be carried out in the early stages, subsidies to this activity would be more cost-effective than wide-ranging protection.

Much of the thrust of the infant industry argument for protection dissipates when foreign direct investment is considered. In cases where the decrease in costs is brought about by initial investment in research and development or in general know-how, the industry can operate at the lowest cost from the outset by attracting foreign investment. Foreign investment and access to international capital markets—which call for nonprotectionist, outward-oriented trade policies—are also the first-best solutions when the problem stems from imperfect domestic capital markets.

Trade economists have consistently pointed out that, in practice, protection has persisted for long periods without evidence of any decrease in costs in the protected industries. On the contrary, there is abundant evidence of resilient inefficiency and high costs in protected industries that have been trimmed only by trade liberalization. Also, there is no evidence that higher rates of protection have been accorded to those industries with greater externalities.

Tariffs and the Terms of Trade

In principle, imposing a tariff may be beneficial for a country that can affect the international price of its imports or exports. If exporters do not act collusively but the country as a whole possesses some degree of monopolistic power on export markets, the imposition of an export tariff can imitate the effect of collusion among exporters. Similarly, an import tariff can implement an advantageous pricing strategy when the country has a monopsony on import markets. The optimal tariff would be obtained by setting the benefits—that is, government revenues and private profits—against the costs of the tariff—that is, domestic distortions and misallocation of resources. Although the welfare of the country could be raised in this manner, the welfare of other countries would be decreased in a larger amount. Thus, the gains to one country are clearly achieved at the expense of others.

Small trading economies, such as those of most developing countries, can hardly affect international prices by trading in manufactured or primary products. Those countries, however, that possess the monopoly of a natural resource, such as oil, can improve their terms of trade by restricting or taxing exports. That is also the case of large industrial countries whose volume of international trade accounts for a large share of the international markets. Nevertheless, tariffs motivated by the terms of trade argument are rarely seen in practice. The reason seems to be the fear to trigger a chain of mutual retaliations that would compromise the world trading system.18 It can be shown that when the possibility of retaliation is taken into account, the use of tariffs to improve the terms of trade may no longer be optimal.19 Multilateral trade institutions and the inter-World War experience of trade retaliations seem to have sufficed to enforce restraint in the use of this sort of “beggar-my-neighbor” policy

Strategic Trade and the New International Economics

In recent years, some trade economists have proposed new approaches to the analysis of the gains and costs of free trade.20 In the center of the new theory is the consideration of economies of scale and externalities in some industries. Economies of scale and externalities cause decreasing average costs and thus, larger producers have an advantage over smaller ones. According to this theory, those suppliers that gain initial control of a greater portion of the market will be able to drive competitors out of it and to secure for themselves an oligopolistic position. The “new trade theory” posits that if an industry exhibits these characteristics, a country may be able to gain an oligopolistic or monopolistic power on the international market for the product under consideration. Once a country has achieved that position, it will obtain monopoly profits at the expense of its trade partners. Moreover, if its trade partners pursue free trade policies, the main producer can effectively preclude competition due to its lower costs. By implementing specific industrial policies, such as subsidies and protection, a country can allow selected domestic industries to contest monopolistic positions in international markets and replace existing monopolists.

Free traders have argued that the existence of imperfectly competitive domestic markets greatly strengthens the case for free trade. The larger the market, the less scope there is for monopolistic market power, and free trade greatly increases the size of the market. In fact, free or freer trade has proved to be the best anti-monopoly weapon. Moreover, there is no evidence that international markets are generally oligopolistic. Even in cases where supply is concentrated in a few producers, the threat of new entrants can preclude monopolistic behavior. This threat is particularly present in international markets under free trade.

Krugman21 argues that to design strategic trade policies, governments must have extensive knowledge of many details that are possibly beyond their reach. In addition, the general equilibrium effects of strategic trade policies are uncertain. Since promotion of a particular sector implies drawing away resources from other sectors, the pursuance of strategic trade policies in key industries is likely to generate significant inter-sectoral and intertemporal distortions. Empirical analyses based on general equilibrium models indicate substantial efficiency losses which generally exceed the gains from strategic trade policies.22 Furthermore, adherence to a policy of industry subsidization and protectionism creates powerful incentives for rent-seeking behavior and interest group pressures. Under a policy of discretionary protection, in practice, governments are unlikely to resist lobbying and special-interest politics. Many economists that would, in principle, justify protectionism in some selected cases, consider that an adequate implementation of selective protection is politically infeasible. Consequently, the establishment of a blanket policy of free trade may be the best feasible policy.23

Measuring the Bias of a Trade Regime: Nominal and Effective Protection

The imposition of a tariff on an imported good raises the domestic price of the good. If there are domestic producers of the same good, the tariff shelters them from international competition. This effect is often the main objective of the tariff. Even if it is not the primary objective of the tariff—see below—protection of domestic industries will be, to some extent, an inevitable side effect. Protectionist policies accord different degrees of protection to different industries. Thus, import-substituting industries are generally favored by protection while exporters and producers of nontradables may be impaired. Therefore, a trade regime biases the incentives driving the domestic allocation of resources. When assessing the bias of a trade regime, it is often necessary to quantify the amount of protection that it affords to different industries.

Throughout this section, the discussion will be conducted in terms of nonprohibitive tariffs. A tariff is non prohibitive if the domestic price, exclusive of other domestic indirect taxes, is approximately equal to the international price plus the tariff.24 This is the most common case encountered in practice. Nevertheless, before entering the analysis of nonprohibitive tariffs, it is worth mentioning the following two extreme cases or “corner solutions.” (1) When the international price plus the tariff is substantially higher than the domestic price, the protection afforded by the tariff is equivalent to a ban on imports. (2) The opposite extreme case occurs when the international price plus the tariff is significantly below the price at which domestic producers would be able to supply the good.25 In the latter case, there is no domestic production, and the tariff does not result in protection of any domestic industry—it is, in fact, equivalent to a free trade regime with a domestic excise of the same magnitude as the tariff.26

Having considered the extreme cases, the rest of this section deals with the case in which domestic prices of tradable goods are equal to their international prices plus the corresponding tariffs. The amount of protection is usually expressed as a percentage of the international price. A first straightforward approach is to compute the nominal rate of protection. If the tariff is an ad valorem tax proportional to the value of imports, the tariff rate itself measures the nominal rate of protection. If the tariff is specific, the nominal rate of protection is given by the tariff divided by the price net of the tariff. Thus, the algebraic expression for the nominal rate of protection is


where P1 and PD denote the international and domestic prices, respectively, of the imported good.

The nominal rate of protection does not always give a good indicator of the amount of protection provided to an industry by the tariff system. Protection does not only increase the price at which domestic industries can sell their output. If a tariff applies to intermediate goods, it will also increase the price that domestic producers have to pay for their inputs. On the other hand, if a tariff applies only to the finished product but not to any of its inputs, the amount of effective protection will depend on the magnitude of the value added. When a domestic industry can charge a margin between unitary costs and the price of its output (value added at domestic prices) which is larger than international standards for that margin (value added at international prices), the industry receives positive effective protection. Conceptually, effective protection is the relation between domestic margins of value added and the standards for those margins prevailing in the international markets. A simple example illustrates this point further.

Suppose that a television set sells on the international market for US$800 and the parts of which it is made sell for US$500. To encourage domestic production, a country places a 25 percent tariff on imported household appliances. This allows domestic assemblers to charge US$1,000 instead of US$800. Before the imposition of the tariff, domestic assembly would take place only if it could be done for US$300, which is the difference between the international price of the final good (US$800) and the cost of its components (US$500). After the imposition of the tariff, domestic production will take place even if it costs as much as US$500, which is the difference between tariff-inclusive price (US$1,000) and the cost of its components. That is, the 25 percent tariff rate provides an effective rate of protection of 66 percent. This is the amount by which domestic costs can exceed international costs (US$500 minus US$300) in the assembly industry as a proportion of international costs (US$300).

Now suppose that the country adds a second tariff of 20 percent on imports of television components, raising the cost of components to domestic assemblers from US$500 to US$600. The new tariff makes domestic assembly of television sets less advantageous. Domestic assembly will be undertaken only if its cost does not exceed US$400 (US$1,000 minus US$600). The new tariff, although it extends protection to domestic producers of components, results in an effective rate of protection to assembly of 33 percent (US$400 minus US$300 as a proportion of US$300).

Summarizing, the effective rate of protection for a sector can be defined as the amount by which the value added in the sector at domestic prices exceeds the value added in the sector at international prices expressed as a percentage of the latter. That is,


where V1 and VD denote the value added at international and domestic prices, respectively.

A trade regime may provide different levels of protection to different industries. The rate of protection for a group of industries can be obtained as a weighted average27 of their individual rates of protection. A trade regime is neutral when the aggregate effect of all trade and industrial policies is to offer the same nominal or effective protection to the production of all tradables. In contrast, a trade regime is biased when exportables and importables are accorded a dissimilar degree of nominal or effective protection. A commonly used index of this bias is the ratio of the rates of protection of importables and exportables.

The use of the concepts of effective or nominal rates of protection presents some problems. First, it only takes into account the direct impact of a tariff. If the trade regime were to be changed, indirect general equilibrium effects would take place economy-wide. Empirical studies tend to indicate that nominal and effective rates of protection underestimate the actual degree of protection.28

Second, it is generally true that nominal or effective rates of protection vary widely across industries. Yet, they may have an average value of zero which, on face, implies no protection. The variation, however, in nominal or effective rates of protection across industries is itself an important distortion. Full neutrality of a trade regime requires uniform zero rates of protection across the tradable goods industries.

Neutrality of a trade regime, as defined previously, only implies equal rates of protection across industries of tradable goods. Specifically, neutrality implies that the rates of protection accorded to exportables and importables are the same, that is, the trade regime does not discriminate between imports and exports. Neutrality does not imply that these rates of protection are low or that the trade regime is nondistortionary In particular, a trade regime with high tariffs may still be neutral. If tariffs are coupled with export subsidies, the rate of protection of importables can be equal to that of exportables while the country maintains high rates of protection. Moreover, the relative price of tradables and nontradables will be highly distorted. Therefore, the measure of the bias of a trade regime cannot be taken to represent the extent of the efficiency loss due to protectionist policies.

Optimal Import Tariffs and Tariff Structure

In recent years, policy advice on trade reform, notably in the context of IMF and World Bank adjustment programs, has emphasized the need to lower average tariffs and to curtail the dispersion of existing rates.29 Often, these recommendations were part of reform programs aiming at a low, uniform tariff and at the complete removal of nontariff barriers. The rationale behind these recommendations does not concentrate on a single argument nor is the rationale purely theoretical. A wide scope of considerations, ranging from administration costs to suboptimality of protectionism, points in the direction of a low and uniform tariff. Nevertheless, particular circumstances may justify deviations from this policy or require a transition period between the existing trade regime and the optimal. This section summarizes some of the practical and theoretical considerations in the design of optimal tariff structures.30

Optimal Tariff Structure Under a Revenue Objective

In most cases, the imposition of tariffs is not an optimal policy.31 That is, trade-neutral domestic taxes and subsidies in the case of externalities can raise the same revenue as a given tariff system with lower distortions and efficiency losses.

In practice, tariffs are often introduced by governments seeking to protect domestic producers from foreign competition. Protection of this sort distorts the relation between domestic and international prices prompting an inefficient allocation of resources. As higher prices spread across domestic markets, they impair the exporting capacity of the country through higher costs, lower factor productivity, and currency overvaluation. In the absence of foreign competition, domestic producers often lack the incentive to introduce growth-enhancing new technologies and cost-saving measures. Protection encourages instead unproductive rent-seeking activities such as lobbying and special-interest politics. These activities are undertaken by potential beneficiaries to maintain and extend existing levels of protection. From the revenue point of view, trade-neutral domestic taxation provides a broader base and the possibility of lower tax rates while avoiding inward-oriented biases. According to these considerations, the optimal tariff would be an across-the-board zero rate tariff.

Nevertheless, owing to revenue considerations, a low tariff has been frequently advised. When designing the optimal tax mix to meet given revenue objectives, the distortions introduced by a tariff should be weighed against savings in collection costs and reduction of distortions elsewhere in the economy. Collection costs of international trade taxes are generally lower than those of domestic taxes. The World Development Report32 estimates that the average collection costs of trade taxes are between 1 percent and 3 percent of revenue. In contrast, the same source estimates that the cost of domestic taxation can be as high as 10 percent of revenue collected in the case of income taxes and 5 percent of revenue in the case of the VAT.

The case for a low tariff rests on its small economic cost. The economic cost of levying a tax is a more comprehensive concept than the administration cost. The economic cost is the value of the output forgone due to losses in economic efficiency. The economic cost of a tax rises more than proportionally with the tax rate.33 This is particularly true in the case of taxes on international trade.34 These taxes add protectionrelated efficiency losses to the losses that could be expected from any indirect tax with a relatively narrow base. Efficiency losses related to protection are caused by the inward-oriented bias that tariffs introduce. The discrimination against imported products distorts domestic prices, increases domestic costs, and impairs exporting activities. At low rates, the lower administrative cost of a tariff might prevail over the economic cost of protection. The case for a low-rate tariff is reinforced if existing domestic taxes are costly to administer and highly distortionary, and if fiscal imbalances dictate an urgent increase in government revenue.

Finally, when a country has a complicated tax structure that is difficult to dismantle in the short term, it may become infeasible to increase domestic taxation further. In such cases, the revenue objective and the level of domestic taxation may have to be taken as given.

Once it has been decided to implement a tariff with low rates, there are several reasons to minimize the dispersion of rates.

• Multiple rates substantially increase the cost of administering the tariff. Since low collection costs are an important reason for using tariffs, multiple rates undermine that rationale by increasing collection costs.

• A uniform rate implies uniform effective protection of all domestic industries.35 Provided that exporters are reimbursed the tariff paid on their imported inputs, a uniform rate structure minimizes discrimination between sectors. When inputs are taxed at a lower rate than outputs, industries producing final goods are granted a higher effective protection than other economic activities. In general, a high tariff rate on a product benefits domestic producers of that good and harms those activities that use the product as input. Rate dispersion will produce different levels of effective protection across industries according to the rates that apply to their output and inputs. Exporters occupy a special position in the economy. While the price of their output is generally set by international markets, the price of their inputs—that is, their costs—are increased by protection. Consequently, protectionist policies tend to impair export industries. To minimize this antiexport bias and allow exporters to compete in international markets, it is generally necessary to reimburse the import duties paid on inputs used to produce exports.

• Rate dispersion encourages special-interest groups to devote resources to increase the amount of protection granted to them. Every industry has a strong incentive to press for an increase of the particular rate that applies to their output. In contrast, a clear commitment to uniformity diminishes the incentive to engage in lobbying activities. First, since any increase in the tariff rate gained by a group has to be extended to all imports, the tariff rate increase that any special-interest group is likely to obtain is small. Second, all import-substituting sectors benefit from an increase, irrespective of who devoted resources to lobby for the increase. Therefore, there is an incentive to wait and let other groups bear the cost of lobbying. That is, free riding can be expected to diminish protectionist pressures.36

• The distortions prompted by a tariff grow more than proportionally with the rate. In contrast, revenue grows, at most, proportionally. In fact, revenue should be expected to increase less than proportionally to the increase in rates. This is due to the decrease in demand prompted by higher prices and, perhaps, due to tax evasion and smuggling encouraged by higher tariff rates.

Therefore, to obtain a given level of revenue with the lowest distortionary effect, the tariff should be applied across the board to all imports with a minimum dispersion of rates.

There are also arguments in favor of rate dispersion. The main nonprotectionist argument for differentiated tariff rates is based on the theory of optimal taxation. Optimal taxation is also known as Ramsey taxation after the economist F.P. Ramsey, who in 192737 derived the characteristics that an optimal tax system should have to minimize tax-induced distortions.38 According to the theory of optimal taxation, those commodities for which demand has a lower price elasticity should be taxed at higher rates. The reason behind this prescription is that if the demand for a commodity is inelastic, it will change relatively little after the imposition of a tax. That is, consumers will absorb the tax burden without substantially changing their economic behavior. Hence, to minimize distortions, taxation should concentrate on those commodities.

Another result of optimal commodity taxation is that final goods should be taxed at higher rates than inputs to production. The reason is that tax-induced changes in the relative price of inputs can lead to the choice of inefficient technologies. Some inefficient technologies may become more profitable to the extent of overtaking efficient technologies. Since the tax will be eventually borne by the final consumer, it is better to tax final consumption directly, thereby avoiding production distortions.

Extending that argument, the theory of optimal taxation recommends higher tariff rates on final consumption goods than on intermediate products. Among final consumption goods, those with a more inelastic demand should have higher tariff rates.

The theory of optimal taxation has found very little application in practice. The amount of information required to design the optimal tariff structure is beyond the possibilities of even the most sophisticated government agency. It requires precise knowledge of demand elasticities for all goods and services. Moreover, in a dynamic economy, the characteristics on which an optimal tax structure should be based—price and cross elasticities of demand, preferences, available products, etc.—are constantly changing. The administrative cost of implementing such a system would probably exceed the revenue collected.39

Tariff rates differ widely across commodities in many countries. Nevertheless, the reasons for such rate spread owe little to the theory of optimal taxation. Special-interest groups and lobbying by import-substituting industries often press governments for higher tariff rates on their products and lower tariff rates on their inputs. Most governments implement tariffs to protect domestic industries and, from a protectionist point of view, the optimal tariff structure does not need to exhibit a uniform rate.

Optimal Tariff Structure Under a Protection Objective

In many cases, policymaking needs to operate within the parameters of a given level of protection. The optimal tariff structure under that constraint will depend on the reasons for protection. For instance, if the objective is to reallocate resources toward a particular sector—such as agriculture—and away from other domestic industries, a uniform tariff may be unable to accomplish that goal. Nevertheless, the case for a tariff structure with a single rate or with very few rates within a narrow band, might still be argued on administrative, political, or efficiency grounds.

A common argument in favor of protection is based on the infant industry theory.40 According to this argument, protection is needed to allow some domestic industries to develop. This theory posits that certain industries are initially uneconomic but may become competitive in the long run. These industries, once they are established, generate externalities and experience a decrease in costs that will, eventually, allow them to compete in the world markets. Recently, strategic trade theories have defended protection for selected industries on the grounds that these industries exhibit increasing returns to scale. Therefore, established producers can effectively prevent competition because their costs are lower than those of foreign potential entrants. The markets for their products will necessarily be dominated by a few firms from one country. Protection can allow domestic suppliers to challenge incumbent oligopolists and, eventually, take their place.

If protection is motivated either by the infant industry argument or by strategic trade considerations, the optimal tariff structure would not normally be uniform. Protection should be accorded only to those industries that need it to generate externalities or to contest international markets. When protection must be extended to several industries, the rate of protection accorded to each of them should be a function of its particular protection needs. Overprotection of an industry may eliminate the incentives to invest in cost-saving activities, defeating the very purpose of the tariff.

In the case of a country that possesses monopsonistic power on certain international markets, protection can improve its terms of trade. Since the country can lower the price of some of its imports by restricting demand, a tariff on those imports may improve welfare in the country at the expense of other countries. The optimal tariff structure would restrict protection to those products whose international price the country can affect. The tariff rate on each commodity should be commensurate to the market power of the country.41

Nevertheless, arguments for protection based on terms of trade are seldom employed in practice. Fear of retaliation seems to be sufficient to dissuade governments from implementing this type of policy.42 Observed behavior suggests that when the possibility of retaliation by trading partners is taken into account, a policy of zero tariffs could be optimal.

To conclude, even when tariffs are implemented for protection, uniformity or quasi-uniformity of tariffs may still be defended on a variety of grounds. First, the advantages of a diversified rate structure may not compensate the cost of administering such a system. Second, political economy arguments point to the need for across-the-board rules to curtail unproductive rent-seeking activities. Finally, the practical difficulties involved in identifying the relevant industries or the appropriate rates of protection may preclude the implementation of optimally differentiated rates.

Tariffs on Inputs and Duty Drawbacks

In recent years, many developing countries have undertaken trade reforms to promote economic efficiency and growth. The 1970s and 1980s have witnessed a reversal of import substitution strategies and the adoption of outward-oriented trade regimes.43 Tariff structures have undergone drastic changes as part of trade reforms. The main directions of these changes have been the reduction in average protection rates and the convergence in tariff rates across different imports.

Since outward-oriented trade reforms involve substantive reductions in average tariff rates, they can be almost always expected to result in revenue losses. When domestic tax instruments and institutions are well developed, the revenue loss can be offset by raising trade-neutral domestic taxes. In most cases, however, trade reform involves raising tariffs on the least protected goods to recover part of the revenue lost by the reduction of the highest rates.

Regardless of revenue considerations, reducing the dispersion of tariff rates has been an objective of trade reforms for its own sake. Constraining tariff rates to a narrow band affords similar effective protection to all import-substituting industries, thereby reducing distortions and biases. It also reduces the costs of collection and tends to curtail incentives for tax evasion and smuggling. Finally, a commitment to a uniform or quasi-uniform tariff structure hinders attempts from special-interest groups to attain privileged treatment.

As a result of trade reform, tariff rates on intermediate inputs can be expected to converge to the average rate, thereby increasing operating costs of selected producers across the economy who had faced lower tariff rates on inputs prior to reform. While this increase in cost will tend to level the field among industries that produce for the domestic market, it could impair export industries. Different industries that faced distorted cost structures according to which inputs they use—domestically produced, highly protected, freely imported, etc.—will face, after the reform, a uniform price differential relative to world prices independently of the composition of their inputs. They will also face an equal level of protection on their inputs than on their output. To the extent that exporters cannot affect the price of exports, however, an increase in tariff rates on inputs will damage their competitiveness. Unlike industries producing for the domestic market, export industries will not experience an increase in the price of their output owing to protection.

Despite the success of outward-oriented trade strategies, many developing countries still maintain high levels of protection. Inward-oriented trade regimes are characterized by a wide dispersion of tariff rates and high average rates. Very often, the objective of import-substituting policies has been to protect domestic producers of final consumption goods such as consumer durables, textiles, etc. To achieve high effective protection for those industries, imports of competing products were either disallowed or taxed at a very high rate.

Although inputs were occasionally taxed at lower rates, protectionist policies have proved to result in a substantial antiexport bias. Most developing countries are unable to change their terms of trade because of the smallness of their share in international markets. That is, exporters cannot shift forward the increase in cost via increases in prices. Therefore, the high cost and limited availability of inputs results in a negative effective protection rate for those industries that employ importables to produce exportables.44 The antiexport bias of protectionist policies stems from two concurrent effects caused by tariffs. First, exporters face increased costs of domestic and imported commodities. High costs are not constrained to the increase in the cost of importable inputs owing to the direct effect of tariffs. Increased costs are likely to spread across the economy affecting nonimportables and factors of production such as labor. Second, protection of import-substituting industries attracts resources to those industries at the expense of export activities.

Many of the world’s manufactured exports come from places where exporters face relatively low trade barriers with regard to the taxation and availability of inputs. A key mixed of export success in developing countries is an efficient system for providing exporters with easy access to inputs at international prices. To ensure this, inputs required by export industries—whether directly or indirectly—must be freed from quotas, licensing requirements, delays, and other non-tariff barriers, as well as be exempt from tariffs. This removal of tariff and nontariff barriers must take place even if domestic substitutes for inputs are available. Exports should also be sheltered from the effects of indirect domestic taxation—zero-rating exports in the case of a VAT—so that they can compete in international markets unburdened by domestically generated cost-raising barriers.

One way in which some successful exporting countries have provided exporters with inputs at world prices has been by applying a policy of zero tariffs on all inputs across the board. Hong Kong and Singapore with their virtually free ports are an example of that policy.45 The advantages of a uniform tariff structure will be lost, however, if duty-free status is granted to all inputs of production while substantial protection of final products is maintained.

In cases where significant protection rates prevail for both inputs and final products, exporters should be insulated, to the extent possible, from protection-related cost increases. To this effect, three schemes have been proposed.46

Exemption of Imported Inputs

Exporters can be provided with duty waivers and exemptions from nontariff barriers. To facilitate administration, the coverage of these exemptions may be extended in some cases to inputs employed in the production for domestic markets. Variants of this method have been implemented in Taiwan (rebate based on accounts), Mexico and Morocco (temporary admission), and Indonesia, Thailand, and Korea (duty exemptions). Under these methods, exporters are registered and must submit an export report or plan including a list of necessary inputs to obtain a license. Usually, if the proportion of exports to total production is higher than a given threshold, an exemption of 100 percent of imported inputs is granted.

Efficient implementation of these schemes presents several obstacles. First, it is administratively difficult to extend exemptions to imported inputs employed indirectly. In the absence of a similar exemption for domestic producers of intermediate goods used by exporters, domestic inputs may not be able to compete with direct imports. Second, it is equally difficult to ascertain whether a producer is above or below the threshold on exports that warrants a full exemption of tariffs on inputs. Also, when exporters obtain exemptions only to the extent that inputs are effectively used in the production of exports, it may be necessary to monitor the technical requirements of different production activities. If the use of exempt inputs cannot be reasonably monitored, tax revenue will be eroded and domestic inputs will be displaced by duty-free imports. A possible solution to this problem, implemented in Korea and Taiwan, is to determine and publish regularly a matrix of technical coefficients for the main export commodities that is, then, applied in all cases. Similar methods have been implemented in Bangladesh, India, and Pakistan with assistance from the World Bank. Morocco applies a system of exemptions based on declarations by exporters that are verified by customs officials within six months. It should be noted that when duty-free imports can be deviated into the domestic market where they are sold at (higher) domestic prices, the opportunity cost of inputs to exporters is given by the domestic price. Therefore, even small spillovers of duty-free imports into the domestic market can neutralize the attempt to develop a competitive export sector.

Duty Drawbacks

Under this method, duties and other indirect taxes actually paid on inputs are rebated to exporters. Duty drawbacks have been used in order to meet the needs of small or occasional exporters. The system has also been used when imported inputs represent a small proportion of total inputs in the exporting sector. Duty drawbacks, unlike most direct export subsidies, are allowed by GATT rules. An important industry in which duty drawbacks have been used to isolate exporters in both developing and industrial countries is the auto industry (Brazil, Mexico, the United States, and others). Different versions of this method have also been implemented in Korea, India, Indonesia, Taiwan, and Thailand.47 Owing to administrative considerations, a scheme of drawbacks should include a standard rebate for each regular export product and the possibility of filing a claim, supported by evidence, when a higher rebate is sought.

Bonded Factories and Duty-Free Export-Processing Zones

The system of bonded factories involves bringing in the inputs and shipping the exports under customs seal. Under this system, the physical location of the factory is not geographically constrained. Mexico and Mauritius, among other countries, have employed the in-bond manufacturing system.

As an alternative to in-bond manufacturing, many developing countries have established duty-free export-processing zones. The reasons for the implementation of this system have been diverse. Regional development objectives, pressures from domestic special-interest groups, the intent to bypass necessary liberalization of the trade regime, the assessment that the administrative demands of bonded factories were beyond existing capabilities, or the desire to emulate the success of East-Asian export processing zones have been behind the wide popularity of this system. Thomas and Nash report that at least 30 developing countries have introduced different forms of duty-free areas to promote export activities.48 In practice, the results have been mixed and many of these initiatives have performed very poorly as a result of unfavorable location, high starting costs, lack of necessary institutions and infrastructure, and shortcomings in their administration. The approach has been most successful where export-processing zones were part of a general environment favorable to exports and foreign investment.

The theoretical analysis of duty drawbacks, tariff exemption of export inputs, and other methods of isolating exporters from inward biases created by protectionist policies is still scarce. It is generally accepted that a first-best approach would require the removal of protectionist policies, eliminating thereby the need to insulate exporters from the damaging effects of protectionism. When some level of protection is taken as given, duty drawbacks may improve the competitiveness of export industries at the expense of introducing new distortions. That is, duty drawbacks are a second-best policy. The main distortion introduced by duty drawbacks is a bias in favor of imported inputs. Domestically produced inputs will generally have a domestic price above their international price owing to the protection accorded to import-substituting firms. When an exporter purchases those domestic inputs, he cannot obtain a refund of the amount by which their domestic price exceeds the international price. In contrast, if the same exporter imports his inputs—which might be identical to those domestically produced—he will receive a duty drawback. Therefore, when inputs are imported—rather than bought from domestic producers—the price effectively paid by exporters is the international price instead of the higher domestic price.

A particular instance of this distortion occurs when different export industries use different amounts of nonimportables, such as labor. Those export industries that are more intensive in the use of nonimportables will be disadvantaged with respect to those that are more import intensive. This bias will operate independently of the comparative advantage of the country, which might very well lie in the intensive use of nonimportables as inputs.

Panagariya analyzes the effects of input tariffs on welfare with and without duty drawbacks.49 He finds that when protection is extended to inputs, the implementation of duty drawbacks is welfare-improving up to a point. The reason is that export drawbacks allow a partial correction of the anti-export distortions introduced by protection. This effect generates a structure of exports more in accordance with the underlying comparative advantage of the country. Nevertheless, some exporters may switch from domestic to imported inputs to escape higher domestic prices, as previously discussed. In some cases, this will occur even when the adopted technology is less efficient (at world prices). When tariff rates are high, the latter inefficiency offsets the beneficial effect of the drawbacks. J. Behrman and S. Levy also analyze some conditions under which export drawbacks may be welfare-reducing.50 If the country exports several goods and they are produced with different combinations of domestic and imported inputs, those exports that are import-intensive will be favored by tariff rebates. In this sense, export drawbacks are similar to a system of arbitrary export subsidies since they are not based on considerations of comparative advantage. Instead, the drawback system favors those exports with a larger proportion of imported inputs.

Export Duties and Windfall Gains

Export duties play an important role in the tax structure of some developing countries. Most export duties are levied on primary commodities by countries where exports are concentrated in a few products and represent an important part of their GDP. Around 1980, export duties existed in 67 countries.51 While since then, more countries have abolished export duties, many countries remain that continue to use selective export duties for revenue purposes. Sanchez-Ugarte and Modi present a sample of 29 selected developing countries where export taxes were specially significant around 1980. In the sample countries, export tax revenue ranged from 5 percent to 32 percent of total tax revenue and from 1 percent to 7 percent of GDP. During the 1980s and early 1990s, Cameroon, Costa Rica, Côte d’Ivoire, El Salvador, The Gambia, Grenada, Guatemala, Haiti, Jamaica, Malaysia, Peru, Sri Lanka, Togo, and Western Samoa either abolished or significantly reduced export taxes. Nevertheless, they are still a substantial source of revenue in Burundi, Central African Republic, Colombia, Ethiopia, Ghana, Honduras, Mauritius, Rwanda, Sierra Leone, Solomon Islands, Swaziland, Vanuatu, and Zaire.52 In most cases, export duties are levied on one or two commodities that account for a large share of the exports of the country. Coffee is the most commonly taxed product. Other taxed products comprise bananas, cocoa, copra, coconut products, timber, and sugar. A second category of taxed products are the outputs of the mining and petroleum industries, including diamonds, and petroleum.

Export duties have been defended on a variety of grounds: (1) to reduce supply and improve the terms of trade; (2) to substitute for income taxation; and (3) to stabilize export revenue and tax away windfall gains. As a source of government revenue, export taxation is inferior to domestic tax instruments such as taxation of profits. Although in theory and under certain conditions, taxation of exports might reduce supply and improve the terms of trade of a country, empirical studies53 show that, in most countries, exports have been overtaxed, leading to excessive reduction in supply and to a loss of foreign currency earnings. Also, the evidence strongly suggests that export taxes have failed to stabilize producers’ incomes in most cases.

Generally, the removal of export duties has been part of tariff reform programs aiming to establish outward-oriented trade regimes. When export taxes are levied to raise revenue from the profits of exporting companies, the goal can be better served by means of domestic taxes on company profits. Often, the objective of export duties is to indirectly tax small farmers, whose income is difficult to bring into the tax net through conventional income taxation. Even then, a similar result may be obtained by taxing commercial intermediaries through excise or profit taxes. Furthermore, the implementation of a land tax and methods of presumptive taxation could curtail possibilities of tax evasion in rural areas. Moving toward trade-neutral taxes eliminates the bias against export-oriented activities and reduces efficiency losses in domestic markets. Export duties, however, are often part of an environment characterized by weak tax administration and a lack of domestic tax handles.

Implementation of Export Taxes

Explicit export taxes

Export taxes are not necessarily payable on all exports, and their rates vary across commodities. Even though the statutory rates can be ad valorem, specific, or composite, the latter (also called sliding scale) is the most common. The composite tax rate can take the form of a basic tax set on the basis of a reference price and a progressively rising rate on successive price increments. In that manner, the effective rate is an increasing function of the price prevailing in export markets. For example, Costa Rica implemented for some time a system of increasing ad valorem rates applied to that part of the price exceeding a tax-free minimum. The minimum was calculated to cover average costs and normal profits. Some countries, like Ethiopia, tie the rate to the volume of exports. Specific rates are the least common form of duties.

Progressive rate schedules have been justified as a way to tax away excess profits caused by price volatility. Another declared objective is to equalize profits across different agricultural activities to reduce the dependence on a single crop and diversify exports. Changes in prices, however, are not always paralleled by movements in profits, which should be the relevant base of taxation. Moreover, there is, in general, little rationale for progressive taxation of company profits. Extraordinary profits in some years may be necessary to offset lower profits or losses in other years to obtain a normal average profitability. They might also be necessary to induce investment in risky activities—such as those characterized by high price volatility. In any case, there is no reason to single out export industries and to subject their profits to a different tax treatment from those of other sectors. Domestic and foreign competition are, on the other hand, the only effective way of eliminating excess profits and prompting diversification into other products that might offer profitable opportunities.

State marketing boards and stabilization funds

State marketing boards are public institutions that intermediate between local producers and world markets. Generally, they are granted by law a monopolistic position as commercial intermediaries for the relevant commodities. That is, state marketing boards set the price at which they buy the designated crops from local producers for subsequent sale in the international markets. Stabilization funds, on the other hand, do not usually undertake direct purchasing and export activities. Rather, they set domestic prices for local producers and commercial margins for intermediaries, but leave to private firms the actual operation of export activities.

Generating revenue has seldom been the objective of state marketing boards and stabilization funds. Instead, they have been established with a variety of other purposes:

• Stabilization of domestic prices and incomes. To this end, marketing boards and stabilization funds set local producer prices at a level meant to remain stable, independently of oscillations in world prices. Since this domestic purchasing price is set as an average, these boards undergo periods of surpluses or deficits depending on international market conditions. Their funds, provided by past surpluses, are used to compensate for eventual losses due to cyclical movements in the international markets. To the extent that conditions are favorable in the international markets, the price setting mechanism produces a surplus, acting as a tax. In periods of low international prices, the system produces a deficit, subsidizing local producers. In practice, however, surpluses obtained in good times have sometimes not been sufficient or have not been used to compensate for losses incurred in other periods.54 Although data on the variability of producers’ incomes are scarce, Sanchez-Ugarte and Modi find evidence that the variability of producers’ incomes have been actually larger than that of export earnings in most cases they analyze.55

Improvement in the terms of trade. This objective is feasible only to the extent that the country has an international monopoly on the product or engages in oligopolistic agreements with other producer countries. When that is the case, centralizing international trade to affect prices may benefit the country at the expense of its trading partners. Nevertheless, this strategy is likely to produce only short-term benefits. The supply of agricultural products has often proved to be highly elastic in the long run. In the presence of extraordinary profits, other countries may be expected to enter the market, causing a permanent drop in prices.

State marketing boards and stabilization funds have been complicated in their operation and have often fallen captive to special-interest groups. Lack of transparency in their operation has also prompted sometimes wasteful uses of their revenues and rent-seeking activities.

Taxation through exchange rates

An effect similar to the taxation of exports can be accomplished either by the overvaluation56 of the domestic currency or by the establishment of a multiple exchange rate system. In both cases, exchange controls are needed to buttress the overvalued exchange rate. When the relevant exchange rate for exports is higher than its market-clearing level, exporters receive, in local currency, less than the international value of their exports. Again, if the exchange rate is overvalued and the same rate applies to both imports and exports, in effect, importers receive a subsidy at the expense of exporters. When a multiple exchange rate system applies, in which exporters face an overvalued rate while importers face an undervalued rate, the gains from arbitrage accrue to the central bank or result in cross-subsidizing preferential activities.

Although the effects of these mechanisms are similar to a tax on exports, they have rarely resulted in increased government revenue. Instead, the revenue obtained from foreign exchange operations has financed eventual quasifiscal deficits incurred by the central bank. In many countries, overvaluation of the local currency or subsidized exchange rates for imports of selected products have been used for the reallocation of resources. Thus, income effectively generated in export activities has been transferred to urban manufacturing industries or to subsidized imports of consumer goods.

The use of distorted exchange rates is specially harmful because it compromises the sustainability of the trade position of the country in the long term. On the domestic front, the induced misallocation of resources and efficiency losses spread throughout the economy owing to the central role played by the export and import industries.

The Rationale for Export Taxation

Market imperfections

The implementation of different forms of export taxes and nontariff barriers to exports—for example, “voluntary” export restraints—have been defended with two arguments based on market imperfections: the optimality of tariffs when the country possesses monopoly power in the export market and the need to respond to the imposition of trade barriers by importing countries.

The first argument is that when a country possesses monopoly power in the market for a product, it can increase its welfare by following monopoly pricing strategies. In particular, an export tax can induce a reduction in the supply of the commodity, thereby increasing its price. Under an optimal tariff, the country maximizes the monopoly profits obtained at the expense of its trading partners. From the viewpoint of the world as a whole, the outcome of this strategy is welfare-decreasing.

Sanchez-Ugarte and Modi analyze existing export taxes in the light of this argument, reaching the conclusion that exports are being overtaxed vis-à-vis the optimal export duty.57 Other analyses also point to the irrelevance of the argument in many practical cases.58 It has been noted that when the possibility of retaliation is taken into account, the pursuance of monopolistic strategies fails to be optimal. Furthermore, monopolistic positions in agricultural markets are generally contestable. In the presence of world prices substantially above the average cost of production, countries with less comparative advantage than the initial monopolist will enter the market and drive the price down permanently.

According to the second argument, the imposition of trade barriers by importing countries—or the threat of them—may justify corresponding export duties. When a large importing country or a group of countries introduce import restrictions on a product, its price will increase in the markets subject to restrictions. As a result, domestic producers of the exporting country will have an incentive to overproduce if they expect to sell part of their output in the high-price markets. To neutralize the increase in supply and maintain international prices, authorities of the exporting country can impose a tariff on exports.

Export taxes as a substitute for income taxes

Governments may consider export taxes as a straightforward method of collecting revenue. In this sense, export duties can be considered similar to an excise,59 that is, the tax will generate revenue while reducing the level of exports. In many countries, the declared target of the tax is the income of export companies. Export taxes can also be used to tax agriculture and rural producers that are difficult to reach through domestic taxation.

A tax on exports decreases the export price of a commodity relative to its domestic price. Thus, output is redirected toward domestic markets resulting in a distortion of local prices and a misallocation of resources. The tax also creates a “wedge” between the domestic and international prices which leads to further distortions. A tax on exports causes an outflow of resources in the export sector toward less efficient uses. The economy-wide loss in efficiency is similar to that caused by an import tariff. It has also been argued that the supply of exports is relatively inelastic and that, consequently, export taxes are nondistortionary. Empirical evidence shows, however, that the supply of exports is affected by changes in producer prices.60 Furthermore, high export revenues do not always correspond to high profits. Domestic income taxation avoids anti-export biases and targets directly the intended tax base.

Stabilization purposes and windfall gains

Export taxes have been defended as a mechanism to diminish the volatility of earnings in the export sector and the international and domestic price of exportables. The first-best solution is to make use of the market for that purpose, that is, to use futures and financial derivatives to sterilize risk and to implement insurance schemes of voluntary participation and subject to competition. If producers or exporters derive any gain from stabilizing their earnings, they will be willing to enter into insurance contracts.

It has also been argued that export taxes can be used to tax away windfall gains. These gains, prompted by unexpectedly high international prices, can be considered rents. When the tax is applied, it is too late for the exporters to modify their economic behavior. Thus, the tax is nondistortionary and, hence, efficient. Nevertheless, the case for the efficiency of export taxes only holds if the levy is not anticipated. That is, the argument could justify a one-time unexpected levy; it does not justify recurrent taxes on exports. If exporters anticipate that the government will impose a tax on exports in the event of high earnings, they will modify their economic behavior accordingly. Moreover, exporting activities are not a one-shot game. Once the government has levied an unexpected tax on exports, although exporters cannot modify their past behavior, they will modify their future behavior. They will assign a high probability to a similar tax being levied again when similar circumstances occur.

Taxation of Income

Source Versus Residence Principle

Angelo G.A. Faria

  • How should international income be taxed using the source and residence principles?

Taxation of productive factors in an economy—whether directly or indirectly—involves balancing national against international considerations. At the national or “closed economy” level, policymakers are concerned with the revenue, allocative efficiency, and equity consequences of taxes viewed as explicit factor price wedges that influence savings and investment decisions exclusively within the domestic economy, but without any leakages. With extension to a global or “open economy” context, however, such purely national tax systems can exert profound effects on the volume and allocation of international production factors and vice versa, the consequences being crucially dependent, for any one country, on its relative economic standing in the global economy. These effects arise because the factor returns and the underlying tax bases straddle national boundaries, thereby creating the scope for built-in conflict and competition in demarcating tax jurisdictions.

To deal with such conflicts, there are essentially two conceptual adjustments, supplemented by explicitly negotiated schemes of tax harmonization or coordination. One set relating to direct taxation is represented by the residence and source principles. Analogous to these for indirect taxes, such as VAT, are the origin and destination principles. In this section, we consider only the first set of principles.61 These must be regarded as polar principles, and countries in practice adopt some composite, reflecting the growing integration of factor markets (especially capital markets).

The Residence Principle

This principle—also denoted as the nationality or domicile principle—asserts that natural persons, or individuals, are taxable in the country or tax jurisdiction in which they establish their residence or domicile, regardless of the sources of income. For a legal person, or nonindividual legal entity, establishing residence is less clear-cut, although it has increasingly been tied to the location where its business activities are registered and/or its management and control are effectively exercised. In some countries—notably the United States, Canada, and Australia—the concept of residence is more narrowly and legally defined in terms of nationality. In these countries, a natural person is taxable on the basis of his citizenship rather than physical residence, while a legal person is taxable in the place of its registration or incorporation rather than where it carries out its activities. From the standpoint of taxation principles, taxing factor income based on residence more closely approximates the equity or ability-to-pay principle. In relation to capital income, a wholly residence-based tax, because it focuses on the residence of the saver, can be viewed as a tax on the ownership of capital and thus on savings.62

The Source Principle

The source principle asserts the prior, and even sole, claim of the source country, or country in which the income arises to natural or legal persons, to tax such income without reference to other criteria or physical presence or legal residence. Clearly, taxing income on a source basis is ad rem in nature and approximates the benefit principle. It also amounts to a tax on the location of capital, or investment, because it disregards the status of the investor in favor of the siting of the investment.63

Application of the Residence and Source Principles in Practice

Taxation of income by adherence to pure principle is tantamount to taxing net national product (residence principle) or net domestic product (source principle) because the former taxes residents’ worldwide income and the latter all income produced by domestic factors irrespective of their owners’ residence.

In practice, as noted above, countries have tended not to stay with the pure application of one or other principle, but to apply a mix of residence- and source-based direct taxation, the former for nationals residing in the country and the latter for income earned within the country by nonresidents and/or nonnatural persons. The precise nature of mixes has depended on each taxing jurisdiction’s perception of the relative importance of a number of factors, notably the attractiveness of foreign investment, the revenue implications, the domestic administrative capabilities, and the degree of cooperation with competing jurisdictions that it can expect.

Regrettably, even such mixes have not tended to be uniform, thus resulting in potential double taxation of the same income. For example, developing countries, as a broad group, have generally forgone taxing foreign income of residents primarily on grounds of administrative expediency or because the level of income involved was relatively modest, rather than because of a commitment to the source principle. On the other hand, in taxing the domestic source income of nonresidents, they have had to balance their ever-present revenue needs with the resulting disincentive effects on the foreign investor who computes the user costs of capital and services on an after-tax basis.

For developed countries, the concerns are somewhat different because they generally face a relatively more balanced two-way movement of production factors and resource flows among themselves, and a oneway movement toward developing countries. As a result, they remain much more concerned with issues relating to the incidence of taxes on production factors. They each view such incidence essentially from the perspective of a home country trying to approximate the application of the residence principle to the worldwide income before tax of its residents, while continuing to tax domestic source income of nonresidents at an equivalent rate. This explains their interest in transforming the tax principles of residence and source through the provision of tax credit rather than a tax deduction from income for tax levied in a competing tax jurisdiction, within the framework of tax treaties.

Relief from Double Taxation

Angelo G.A. Faria

  • Should double taxation of income be reduced through granting income deduction or tax credit?

When a tax jurisdiction in the home country (i.e., in which the taxpayer is resident) is faced with taxing the foreign-source income of residents and/or the domestic-source income of nonresidents, double taxation of such income would normally result. In principle, this could be mitigated if all countries were to harmonize their treatment of cross-border income flows by agreeing to accept either one or other of the residence or source principle as the single organizing principle in their international tax relations. This is generally not feasible, however, because restriction to the residence principle would for developing, capital-importing countries deprive them of what they regard as a fair share of their somewhat limited tax base, while restriction to the source principle would for developed, capital-exporting countries be viewed as compromising the equity characteristics of their tax systems. Hence, the only practical choice available to a domicile-taxing jurisdiction wishing to minimize departures from neutrality in the taxation of productive factors is to introduce unilateral tax relief. In due course, it may also seek to negotiate bilateral tax relief through tax treaties.64

Unilateral tax relief against double taxation by a taxing jurisdiction or country of a resident’s foreign-source income can take two forms. First, through income deduction, under which such income, when it accrues, is wholly exempted, or is assessed net, after deduction of foreign taxes which are treated as charges or costs. Alternatively, such net income may be assessed only when it is repatriated—the so-called deferral provision. Second, such income may be assessed on a gross basis, but a partial or full tax credit in respect of tax paid in the source country would be offered. Neither form is ideal from the standpoint of inter-nation equity or neutrality, in part because an equiproportionate distribution between revenue gain to taxing authorities and sacrifice to taxpayers cannot unambiguously be assured.

The income deduction approach

For a home country, the deduction approach clearly yields more revenue and is simpler to apply and administer. Revenue gains would result when the home country rate was equal to or higher than the foreign country rate. The simplicity in application is due to the equivalence of net income as determined under the home and foreign country tax codes not having to be established. For example, with a multinational firm operating in several tax jurisdictions, it is always problematical to establish net profits and resulting tax burdens in relation to the true levels of gross income and associated costs, which is applicable to a particular taxing jurisdiction. This is because such cross-border activities give rise to complex trading arrangements by the firm at less than “arm’s length” involving transfer pricing, intercorporate subventions, royalties, etc., to reduce the total tax burden. A deduction system obviates the problem of what taxes should properly be allowed as equivalent to an income tax, or whether different nominal rates exist, by treating all foreign taxes as profit-abating charges or costs.

The tax credit approach

On the one hand, these advantages of the income deduction approach represent the mirror image of the disadvantages of the tax credit approach. On the other hand, the latter’s principal advantage is that it eliminates or at least reduces the double taxation burden, depending on whether full or partial credit is given. From the standpoint of tax incidence, granting full tax credit for foreign tax would mean that a resident in his home country would effectively be taxed on the residence principle applied to his (before tax) worldwide income because he pays the same tax rate on his domestic source and foreign source income. Moreover, it brings the foreign country closer to an effective source principle by reducing the combined tax rate (home plus foreign) on a nonresident’s income in the foreign country. Of course, this outcome is weakened when the foreign tax rate is lower than the corresponding domestic tax rate, thus limiting the tax credit given in the home country to the latter rate.

Aspects of Tax Treaties

Angelo G.A. Faria

  • What are tax treaties between countries designed to do?

Where the inherent conflict between the residence and source principles of taxing income is not unilaterally resolved through a residual tax crediting or an income deduction approach, competing tax jurisdictions can more rationally avoid or reduce double taxation through concluding tax treaties. In fact, such treaties have initially been contracted on a bilateral basis between developed countries where there has been a mutuality of interest allied to a rough balance of income flows between the contracting parties. Over time, however, these treaties have been marked by significant divergences relating to concepts, structure, and operating rules.

To promote greater uniformity in cross-border tax treatment of income, ad hoc groups of experts or governmental representatives have attempted to shape generally acceptable international rules in the form of multilateral tax conventions or guidelines. These rules address objectives in tax relations between source and residence or domicile countries, such as the assignment of specific taxes, a standardized definition of the tax base and its appointment, limitations of tax rates by source countries, and alleviation of double tax burdens. As examples, an Andean model was published in 1971, a revised OECD convention in 1977, and a United Nations convention in 1981. While industrial countries have generally preferred the residence or domicile type of treaty (extended in the case of the United States to emphasize its nationality orientation in taxing worldwide income), developing countries have sought to assert the source principle especially for income from movable capital.

Tax treaties cover a wide number of complex and conflicting conceptual and technical concerns of the contracting parties about sharing income-taxing jurisdiction. They distinguish in particular between primary income earned on “immobile” factors and secondary income from “mobile” factors. In this section, rules of accommodation for only a few of these will be highlighted.

Permanent establishment

The concept of “permanent establishment” has evolved over time in importance because it represents the litmus test between trading in a country and trading with a country.65 Once it is accepted that trading is taking place in the source country through a permanent establishment, its right to share in the resultant tax base is unambiguously established. Thereafter, the relative shares of the source and domicile country can be established through arbitration between them. Trading in a country through a permanent establishment implies, for any business, its having a fixed presence (e.g., office, factory), carrying out business activities over an extended period, or habitually exercising an independent status in negotiating contracts. By contrast, where a business maintains a merchandise stock exclusively for purposes of auxiliary activities such as storage, display or delivery, or trades through a broker or general commission agent, it is considered to be trading with the source country and thus not to be taxable by the latter.

In practice, source countries attempt to expand the interpretation of permanent establishment including auxiliary activities such as trading, while domicile countries take the opposite stance. For both groups, the principal consideration has to do with widening their respective tax bases and thus augmenting potential tax revenue. This is especially the case for developing countries whose purely domestic tax bases are relatively narrower, leading them to press for the source-based taxation even of auxiliary trading activities. On the other hand, domicile country positions are influenced primarily by the need to ensure equitable tax treatment of resident nonnationals and nationals, and to reduce residual double taxation that may otherwise result through the application of the foreign tax credit.

Once trading through a permanent establishment is confirmed, the tax base still needs to be defined. A particular problem is whether dividends, interest, and royalty payments should be taxed on a gross or net basis. Generally, because of administrative difficulties in establishing genuine or “arm’s-length” cost-price relationships between the domestic subsidiary and its foreign parent, source countries prefer the net basis. Residence countries, on the other hand, prefer the gross basis, but seem more disposed to accept at face value the estimates of costs relating to such foreign income.


The tax treatment of corporate distributions is a particularly difficult specific problem faced in concluding tax treaties, in addition to the general difficulties arising out of the source versus residence approaches to taxation. This is because countries have differing views on whether, for tax purposes, a corporation should be viewed as distinct from its shareholders, and also on whether there should be differential tax treatment of retained and distributed corporate profits to provide incentives for reinvestment.

Traditionally, dividend income is treated as taxable in the country of residence/domicile of the shareholder. On the other hand, the country in which the distributing corporation has its fiscal domicile is also recognized as having the right to tax dividends paid out to shareholders, in addition to taxing the corporation itself, based on the source principle. The inherent conflict in the unrestricted application of these two approaches can be reduced within the framework of tax treaties by reciprocity provisions. Developing countries’ desire to capture some part of the profits distributed to foreign shareholders without excessive administrative difficulty is agreed to under such provisions by, for example, a final withholding tax ranging from 15 percent for natural persons to 25 percent for legal persons. The recognition by capital-exporting countries of the right of the source country to tax dividends is a development of some significance for developing countries. Nevertheless, foreign corporations have invested in capital-importing countries using a branch instead of a subsidiary, thereby hoping to escape with payment of tax on profits only and not of distributions of these profits to shareholders. This is because branches earn profits exclusively as dependent agents for their headquarters, whereas subsidiaries exercise independence in earning and distributing their profits to shareholders, the principal one being the parent company.


As with dividends, the traditional attitude is to give the investor’s domicile country the principal right to tax interest payments arising from debt claims of every kind, irrespective of whether these are secured by mortgages or carry the right to participate in profits. Increasingly, however, tax treaties recognize the right of the source country to have a limited share of the tax base through imposition of a modest withholding tax on recipients, say 10–15 percent on the gross amount of interest. This modest rate reflects the recognition that lenders, being interested only in net interest rates, will be influenced adversely if a high tax rate lowers their net return to lending. On the other hand, borrowing countries tend to view low taxation of interest payments as encouraging excessive debt rather than equity financing of business operations, thus serving a mechanism for reducing their true share of the tax base.


Royalties or rental payments are made as a consideration for the use of, or the right to use, any copyrighted patent.66 Examples include films, tapes, trademarks, secret formulas or processes, and commercial or scientific equipment. Here again, there is scope for conflict as regards the taxing rights of the debtor and creditor country. This conflict relates primarily to whether such payments should be taxed gross or net after permitting costs; and, secondarily, where the patent is used in several countries with varying degrees of application, how to establish a source or debtor country’s share of gross payment and associated costs.

Capital gains

The taxation of capital gains also presents difficulties, in large part because taxing jurisdictions have an even wider than normal variation in the tax treatment of such gains and, to a lesser extent, on whether these are from short-term financial assets or longer-term real assets. The general consensus is that where gains arise from the sale of business property, the source country is entitled, together with the domicile country, to levy tax on these gains. This is because the asset sold formed part of a “permanent establishment” for trading in the source country. All other capital gains are normally taxable in the domicile country because this condition is not present.

Tax sparing

This refers to a scheme for allowing the “spared” tax on income arising to a foreign investor in a capital-importing source country to accrue to his benefit fully and directly, rather than perversely to become a revenue transfer from the source-country treasury to that of the domicile country. Thus a domicile country that applies the foreign tax credit would, under tax sparing, allow the spared tax to be fully credited against its own tax. While such relief can, in principle, be provided unilaterally, in practice, it is used as a “sweetener” by capital-exporting countries to encourage capital-importing countries to contract double taxation arrangements with them. The United States does not support tax sparing because it holds the view that it encourages short “fly-by-night” investments because it provides no incentive to reinvestment. Accordingly, the United States takes the view that “tax deferral”—or their delayed taxation from time of accrual to time of repatriation—of the undistributed profits of foreign affiliates is preferable because it promotes long-term investment in capital-importing countries.

Exchange of information

Tax treaties generally contain some provision for the exchange of information with tax implications between national tax jurisdictions. Normally, a country seeking information from another country would limit itself to seeking the kind of information that would be available to it within its own borders. Thus, the exchange should pose no special problems. One area which does pose particular difficulty, however, concerns obtaining information about taxpayers from their bankers because taxing jurisdictions differ about both their power to obtain such information and the prior conditions that need to be satisfied. Generally, capital-exporting countries which tax wide income on a residence and/or nationality basis are especially interested in contracting tax treaties with broader information exchange provisions; by contrast, capital-importing countries taxing on income source basis have a less pressing need to do so, except in cases where a multinational business subsidiary enterprise trading by way of a permanent establishment is suspected to be engaged in less than arm’s-length transfer pricing or of head office arrangements with its parent.

International Capital Flows

Angelo G. A. Faria

  • How should the returns from international capital flows to capital-importing and capital-exporting countries be taxed?

International capital flows imply the existence of exporters and importers of capital on a gross or net basis, each group with its specific views of the marginal social cost and return on investment after allowing for risk differentials. On a gross basis, countries can be both importers and exporters of capital. On a net basis, however, industrial countries as a group are exporters while developing countries are net importers. This stylized feature of the global economy figures prominently in the traditional analysis which implicitly assumes countries to be in rough balance as both capital exporters and importers.

International capital flows are clearly influenced, inter alia, by the total taxation burden of income arising from the claims of overlapping national tax jurisdictions.67 An economically efficient system of global taxation of income returns from such flows would be one characterized by “tax neutrality” in which business decisions relating to location of investment were unaffected by international differentials in tax rates or types of tax treatment. A more realistic view of tax neutrality would be to see it as a standard against which the distortionary effects of taxation on investment and savings, both intended and unintended, could be minimized through mechanisms such as a foreign tax credit and income exemption and even multilateral tax treaties.

Two established and theoretically optimal concepts of tax neutrality in relation to capital flows have been well explored.68 Viewed from the standpoint of across capital-exporting countries, capital export neutrality (CEN) prevails where the tax system is neutral toward the export of capital in the strict sense that investors face the same marginal effective tax rate on total return from similar investments at home or abroad. Given the assumption of equivalence in marginal effective tax rates, capital export across countries would then be based upon an after-tax rate of return to investment which reflected purely nontax factors related to the marginal productivity of capital. In practice, this highly unlikely outcome could only emerge when uniformity across countries in the definition of the tax base resulted in investors being taxed on accrued worldwide income and receive full credit against domestic tax liability for all tax.

“Capital import neutrality” (CIN) postulates that all investors in one particular residence or domicile country are subject to the same tax treatment, namely, that of the source country of the investment income. This implies that both domestic and foreign suppliers of capital in the source country obtain the same after-tax rate of return on their investment. For CIN to be fully effective in practice, this nondiscrimination in source countries will have to be combined with nondiscrimi-nation in the residence countries—again a highly unlikely outcome in practice.

In evaluating their relative merits in practice, a good starting point would be to ask the relative global priority of moving toward one or the other, and securing a more efficient allocation of savings or investment.

CEN has been sometimes preferred to CIN in achieving economic efficiency—assuming that private savings are inelastic with respect to the after-tax rate of return—because equalizing the marginal productivities of capital across uses and countries tends to result in a maximization of global output from a given global stock of capital.69 Against the supposed advantages of CEN, one may recognize that business taxes can be viewed as benefit-type taxes or user charges for public services so that different tax rates neutralize differences emanating from the expenditure side of the budget which, under a crediting system, would be maintained. But given the general difficulty associated with administering a pure credit system necessary for CEN, and that capital has become the most mobile factor in an increasingly interdependent world, it may be that the foreign income exemption provided by CIN and its emphasis on after-tax rates remains appropriate.

International Transfer Pricing and Taxation

William J. McCarten

  • Why do transfer pricing practices raise problems for income taxes?

  • What is the preferred approach to dealing with those problems?

  • How serious are such problems in practice?

  • What lessons can be drawn by developing countries from international experiences of dealing with these problems?

Defining the Problem

Allocating the global income of multinational enterprises, MNEs, among fiscal jurisdictions for tax purposes is a major source of conflict between tax authorities and the enterprises concerned. Much of this allocation is carried out by setting transfer prices.

In the context of international trade, a transfer price is the price for the internal sale of a good or service in intrafirm trade, that is, in trade between branches or affiliates of a single business enterprise located in different countries. Transfer prices are administrative prices set by the management of transnational or multinational enterprises. If management wants its branches and subsidiaries in different countries to operate as independent profit centers, then it may set these prices as close as possible to the prices that would prevail in market transactions between unrelated purchasers and sellers. Tax considerations, however, may influence management to reject such a profit center or “shadow” pricing strategy. The setting of transfer prices will affect the global tax burdens of multinational enterprises because both import and company taxation of enterprises are based on input and output prices, and effective tax rates vary greatly among countries. Their discretion over price setting gives MNEs the opportunity to design sets of transfer prices for intrafirm trade which reduce their global tax liability or achieve other strategic aims, such as overcoming foreign exchange restrictions. Consequently, jurisdictions with moderate or high business income tax rates are vulnerable to tax base erosion on the revenues they receive from taxpayers with transfer pricing opportunities.

The problem for national tax authorities is to establish and enforce rules for the setting of such prices. Considerations of self-interest should lead governments to regulate transfer pricing in ways that minimize conflicts with other jurisdictions and do not discourage future investment, while, at the same time, safeguarding their revenue bases.

International Guidelines and the Arm’s-Length Standard

One way to avoid international conflict over double taxation issues and to foster a favorable business climate in the host country is for the tax authorities to adopt regulatory criteria that command the support of international bodies. Fortunately, a consensus exists among the Organization for Economic Cooperation and Development (OECD),70 the United Nations,71 and the European Community72 that a single guideline should be employed both by enterprises for setting transfer prices and by taxing jurisdictions in their assessment. This guideline is the arm’s-length criterion. As will be discussed later, however, the arm’s-length criterion is not without its critics. An arm’s-length price is the market price that would have been negotiated by unrelated parties engaged in the same or similar transactions under the same or similar conditions. To prevent the use of transfer price setting for tax avoidance, most countries have established their right to adjust reported transfer prices to conform to an arm’s-length standard. Implementing the arm’s-length principle has proved to be a difficult task for both the multinationals themselves and the tax authorities who regulate them.

OECD Guidelines for Determining Arm’s-Length Price

Following closely on U.S. practice, the OECD endorses four methods of determining arm’s-length prices. These are (1) the comparable uncontrolled price method (CUP); (2) the resale price method; (3) the cost plus price method; and (4) any other method which is found to be acceptable, known collectively as fourth methods.73

The comparable uncontrolled price (CUP) method assumes that a known comparable uncontrolled price exists for the sale or purchase of the same or similar goods to or from independent third parties. Market conditions associated with a proposed CUP exchange should be similar to those which characterize the actual transfer price exchange. Even if an MNE is aware of the appropriate CUP for a given intrafirm trade transaction, tax authorities in a host country may not be able to identify it owing to the informational asymmetry between MNEs and the authorities. Where no close CUP exists, authorities will be tempted to impose observable spot prices for transactions which are superficially similar. This approach can lead to serious distortion in the allocation of profit within MNEs, across taxing jurisdictions. For instance, MNE affiliates occasionally operate at a loss, particularly in developing companies, for strategic reasons such as maintaining market share or retaining security of access to raw materials during a period of weak market demand.

The resale price method takes, as its point of departure, the price at which a product passes beyond the limits of the multinational enterprise through a sale to an independent purchaser. A markup is next subtracted from this price to reflect the costs and profit margin of the foreign-based unit of the enterprise which purchased the good from the producing unit and resold it to the independent purchaser. The residual is deemed to be the arm’s-length price of the original sale. This method is most applicable to cases where the reseller does not add substantially to the value of the product—but is essentially a distributor. For the method to work effectively, comparable markups of independent distributors need to be found.

The cost plus price method is based on the supplier’s cost of the resources used in production of a particular commodity to which an appropriate profit markup is added. The cost plus method is beset by many problems. Like the resale price method, it ignores demand or business cycle conditions and fails to reflect competitive conditions; in addition, it overemphasizes historical costs. This approach is most readily applied in pricing a subsidiary’s output in cases where only one or a few products are produced, where the subsidiary performs the role of subcontractor, or where a specialized product has been produced, tailored to the needs of a specific customer—that is, where there are no important manufacturing intangibles. Finally, employing this method in a satisfactory manner requires the determination of an appropriate profit markup and the identification of appropriate costs of production.

The fourth methods of acceptable alternatives include a wide mixture of techniques with different rationales, including profit-splitting according to allocation formulas based on sales, and expected or normal returns on capital invested by an affiliate.74

MNEs may occasionally favor the application of fourth methods in their own transfer pricing as a means of self-assessing the profit level that a host country’s revenue authority might anticipate from them. If a steady accounting profit is expected by the authorities, irrespective of changes in business conditions, an MNE may reason that it is prudent to generate such an outcome to avoid investigations or the hostility of the host government.75

The first three methods may be effective when dealing with tangible commodities. They are, however, often unworkable in cases where payments are made to the parent corporation for the use of intangible services such as intellectual property, management fees, and other services, which are unique to the parent. Furthermore, tangible property often incorporates important intangibles: for example, not all cars are alike.

How Serious a Problem Is Transfer Price Manipulation?

How serious a problem is transfer pricing for developing countries? Statistical evidence on the growth of the intrafirm component of international trade suggests that the proportion of trade likely to involve transfer prices has increased sharply over the last two decades. Hence, the opportunity for transfer price manipulation has increased, and with it, the danger of revenue erosion from high-tax countries. For example, in 1989, 86 percent of U.S. parent-company imports were from foreign affiliates, while 89 percent of U.S. parent-company exports were destined for foreign affiliates.76 A related important secular trend in international trade has been the growth in services as a component of total trade. With the increased importance in total trade flows of such intangible items as royalties and license fees, the scope for tax avoidance through price manipulation has increased correspondingly. It is very difficult to determine comparable uncontrolled prices for these items and even to determine where such services are performed. Therefore, manipulative price-setting of these services may be one of the most preferred avenues for global tax avoidance.77

Nevertheless, substantive arguments can be made which suggest that MNEs do not abuse their transfer price-setting power to avoid taxes in developing countries. Multinationals may refrain from manipulative transfer-pricing practices in developing countries because (1) marginal corporate tax rates are typically lower in developing than in developed countries, and (2) in cases where the parent enterprise is resident in a country with a foreign tax credit system, corporate taxes paid in a host country can be credited against the tax liability imposed by the home country on remitted profits. At the empirical level, a recent study of transfer-pricing practices in the petroleum industry involving the United States and petroleum-exporting countries concluded that, between 1974 and 1984, MNEs in this industry did not substantially manipulate transfer prices.78

To reach a balanced assessment, however, this sanguine picture needs to be contrasted with important qualifications and counterarguments. First, the deductive arguments ignore the role of tax havens which seek to attract the paper profits of MNEs by guaranteeing a regime of little or no taxation. Relatively stateless MNEs may locate their head offices in such havens to facilitate global tax avoidance, though real control and the source of investment lie elsewhere. In addition, MNEs with headquarters in industrialized countries may require branches and affiliates in capital-importing countries to purchase inputs through other subsidiaries located in tax havens. Second, the assumption that marginal corporate tax rates in developing countries are lower than those found in industrial countries is not valid for a number of Asian and African countries.79 Finally, in setting transfer prices, MNEs may be influenced by considerations other than global tax minimization. They may inflate their input prices as a means of circumventing exchange controls and other restrictions on profit repatriation. They may also wish to disguise the extent of economic rents actually earned in the host economy. High rents may lead to demands for higher wages for affiliate workers and political demands that the host country revamp its tax regime to capture more economic rent.

Finally, it is important to realize that, while abusive transfer-pricing practices may affect a very small proportion of tax revenues in large industrial countries, they can affect a very significant proportion of the tax revenue of a small, poor country when there is significant foreign investment in that country.

Experience of Developed Countries with Transfer Price Regulation

While policy guidelines in industrialized countries usually favor use of the CUP method and discourage recourse to fourth methods, the empirical evidence on transfer-pricing practices suggest that fourth methods are employed more often than any other approaches. Three ex post studies of methods used in resolving U.S. transfer-pricing cases found that fourth methods were used between one third and almost one half of the cases, while the CUP method was the second most likely method to be selected.80

Two promising approaches to curtailing transfer-pricing abuses are international cooperation through the exchange of tax information between revenue authorities in different countries, and advance-pricing agreements (APAs). An advance-pricing agreement provides a means of avoiding uncertainty about the acceptability of MNE practices. This approach, adopted by the United States in 1991, guarantees the enterprises concerned advance approval of their transfer-pricing methodologies, if adequate documentation is provided. The recent report of the European Community on company taxation, known as the Ruding Report, has endorsed the practice of advance-pricing agreements between the tax authorities and MNEs. The Ruding Report suggests that countries involved in intrafirm trade might conclude advance transfer-pricing agreements between each other. This practice has already been initiated by Australia and the United States.81 Simultaneous audits of affiliates of a single MNE in two or more countries have also been undertaken.

Experience in Developing Countries

Tax administrations in most developing countries are poorly equipped to cope with transfer-pricing issues. In particular, they tend to lack the technical expertise needed to challenge prices set by MNEs using the methodologies recommended by international bodies for the establishment of arm’s-length prices. In many cases, developing countries appeal to international guidelines when making transfer-price adjustments halfheartedly. Tax statutes in many developing countries often equate arm’s-length dealings with un-controlled market prices and omit rules for establishing transfer prices when comparable uncontrolled market prices are unavailable. In such situations, the administrative response is often to make arbitrary price adjustments or adjustments which are the outcome of implicit bargaining, while seeking to cloak actual practice under the veil of internationally approved guidelines.

Some developing countries have enacted ad hoc and simple rules which do not provide comprehensive solutions, but nevertheless address particular facets of the problem. These approaches include alternative minimum corporate taxes based on turnover, use of royalty fees based on the volume of natural resource extraction, and the disallowance of deductions, such as royalty payments and interest payments on equity infusions by foreign-based parents.

Examples of these strategies pursued by some Latin American countries are disallowing the deduction of royalties paid to related foreign entities for technological contributions, restrictions on the size of deductions for expenses incurred abroad, and establishing presumptive income for certain activities such as international transport, where the use of separate accounting is particularly difficult.82 These rules have had mixed success. Those that disallow the deduction of royalties or limit deduction of expenses have proved ineffectual, because MNEs will find other methods to repatriate profits from host countries without incurring significant tax liabilities.

Policy Lessons for Developing Countries

As a first step in articulating regulatory policy, developing countries should enact legally enforceable measures against those transfer-pricing practices which are intended to erode their tax bases. In designing these measures, authorities should consider their own national legal traditions. The enactment of transfer price statute provisions will signal that the host government intends to combat manipulative pricing practices and may thereby dissuade potential tax evaders.

If the revenue authorities in a developing country are unable to obtain comparable uncontrolled prices, which of the other two methods sanctioned by OECD guidelines—the resale price method and the cost plus price method—should they use? In principle, the option that should be preferred depends on where the intangibles are located. But practical considerations are likely to be more important in many instances. For example, a developing country will generally have access only to the records of the subsidiary. If a manufacturing subsidiary in the developing country sells to its overseas parent for distribution, the developing country will be unable to apply the resale price method. Nevertheless, developing countries have had some success in adjusting MNEs’ transfer prices under the re-sale price method, when the output is a homogeneous product quoted on an international exchange such as the London Metal Exchange.83 These approaches should be used with caution, if the observed commodity exchange price is for a refined commodity many stages removed from the intrafirm trade transaction. In those cases, adjustment should be made for the downstream value added associated with refining and transportation. Failure to make the necessary adjustments for intermediate value added may produce serious tax distortions and discourage production.84

Country experience suggests that royalty and management fees have been an attractive avenue for remitting profits to the capital-exporting country. Many capital-importing countries employ formula restrictions both on the deductibility of such payments and on the actual repatriation of funds under these categories. A less drastic alternative is to impose withholding taxes at moderate rates on nonarm’s-length royalties and other fees paid abroad. Quantitative restrictions or outright disallowance might still be warranted in cases of such payments to affiliates in known tax havens. While the OECD model tax treaty advocates that royalty payments abroad not be subject to a withholding tax, it does so only for the case of arm’s-length transactions.

Revenue authorities should be diligent in identifying sham transactions and questioning transactions involving the purchase of services from related companies in known tax havens. They should also explore opportunities for international cooperation in the form of tax information exchanges or even simultaneous audits with their counterparts in countries where the parents of their most important subsidiaries reside. These developments can be facilitated by negotiating provisions for exchange of information and other types of cooperation in tax treaties.

Countries may wish to make provision in their legislation for advance rulings. This option should be attractive to a great many MNEs because it would avoid capricious outcomes, wasteful litigation and the un-certainty associated with prolonged disputes. When advance ruling and negotiable agreement are difficult to conclude, host countries may wish to explore the use of international arbitration services such as those provided by the United Nations.

In cases where import tariffs are high or where the enterprise becomes liable to sales taxes on its imports, an MNE may attempt to minimize the price of imported goods by underinvoicing. Customs and income tax departments need to cooperate closely in their tax surveillance activities to ensure that subsidiaries do not adopt a double invoicing system with low prices for customs and high prices reported to the income tax authorities.

Critics of the arm’s-length criterion emphasize its lack of workability, particularly for developing countries, the long delays in resolving disputes arising from its application, and the high costs incurred by tax authorities who attempt to apply it rigorously. They offer as an alternative the universal apportionment method which would assign the global profits of MNEs among tax jurisdictions based on apportionment formulas.

These formulas might contain as components the wage bill or value added of affiliates, the book value of assets, and sales. While such an apportionment approach has been successfully implemented at the state level in federal countries, it has not been applied in the international setting except by the countries of the Andean Pact. Using a universal apportionment formula to allocate the global profits of enterprises operating in both high- and low-wage countries will not produce a desirable tax allocation from the perspective of the latter group of countries, if the wage bill is an important component of the formula. Moreover, regionally based initiatives to replace the arm’s-length standard with formula apportionment would be likely to lead to different formulas in different jurisdictions.

Despite the shortcomings of current international guidelines on transfer pricing, they are unlikely to undergo radical alteration in the future. Therefore, the most effective strategy for developing countries that wish to safeguard their tax revenue bases against abuses of international transfer prices is to devote adequate resources to transfer-pricing regulation within the framework of international guidelines.

Treatment of Subsidiaries and Branches


  • What is the difference between subsidiaries and branches, as forms of business organization?

  • What are the tax and non tax advantages and disadvantages of the two forms of organization, from the perspective of a foreign investor?

  • What justification is there for imposing a special tax on branch profits?

  • What is the problem of “thin capitalization,” and how has this problem been tackled in different countries?

As a general principle, countries should be guided in their tax treatment of branches and subsidiaries of foreign-based enterprises by a desire to achieve neutrality across organizational forms as well as by the need to generate revenue. Complexity is likely to arise in this area of taxation because of the difficulty of harmonizing domestic tax policy objectives with international tax policy guidelines and the provisions of foreign tax regimes.

Defining Branches, Subsidiaries, and Permanent Establishments

A foreign-based enterprise which carries on business operations in a host country, but has not incorporated in the host country, has established a branch. Under a branch, the foreign enterprise usually faces unlimited liability for the debts and other legal obligations of its branch. In contrast, if the foreign-based enterprise incorporated its business in the host country, then a subsidiary exists. Under the subsidiary, liability is limited to the assets of the subsidiary in the host country. An important related concept is that of a permanent establishment.

A permanent establishment, as defined in article 5 of the OECD Model Tax Treaty, is a fixed place of business through which the business of an enterprise is wholly or partly carried on.85 This definition excludes certain activities of a foreign resident in a host state such as conducting business in that state through a broker or general agent or maintaining inventories of goods in the host state for delivery to an agent or purchaser. Once a foreign person acquires a fixed place of business or employs resident individuals, the enterprise is deemed to have set up a permanent establishment. The income producing activities of a business are generally taxable once that business sets up a permanent establishment in a tax jurisdiction. A corollary of this guideline is that foreign persons should not be subject to branch taxation if they have not engaged in activity giving rise to a permanent establishment.

In general, international conventions and bilateral treaties take the view that the profits to be attributed to a permanent establishment are those it would have made had it not been dealing with its own head office, but with an entirely separate enterprise under arm’s-length conditions. If separate accounts do not exist, then revenue authorities will apply the arm’s-length principle in ascribing a profit to the establishment.

Advantages and Disadvantages of Operating as a Branch or a Subsidiary

Nontax considerations

The decision of a foreign-based enterprise to carry on a business as a branch or as a subsidiary will be influenced by both tax and nontax considerations. Among nontax considerations are the type of industry in which the foreign investor intends to operate; the degree of financial liability that the investor wishes to assume; the degree of financial disclosure of its worldwide operations which the investor is prepared to make to the host authorities; and the degree of control which the investor wishes to exercise over its operations in the host country.

Banks and other financial institutions, for example, have often preferred to operate their foreign activities through branches rather than through subsidiaries—and are often required to do so by host governments. The assumption of liability by the parent entity under the branch form may generate more client confidence than would have been the case if the subsidiary form, with liability limited to assets in the host country, had been employed instead.

Tax advantages of the branch form

1. In many countries, including the United States, losses from foreign branch operations are immediately deductible against income generated by the parent on its home country operations. Hence, the branch form of operation will be advantageous to enterprises based in countries which require “accrual” taxation of foreign branches, if losses are expected from foreign activities during the first few years of operation. If its foreign operations subsequently become profitable, the branch may then be incorporated to reap the advantages of tax deferral.86

2. Traditionally, branches were only taxed once on their income or profits, so that any after-tax income might be repatriated to a foreign-based parent enterprise free of withholding tax. In this framework, such repatriated income is not considered to be a dividend or interest. (More recently, many developed and developing countries have adopted a supplementary form of taxation on branches known as a branch profits tax.) By contrast, the return on capital invested through a subsidiary is usually taxed twice; once at the corporate level and again, when dividends or interest are remitted, with a final withholding tax. If the host country operated an imputation system for the relief of corporate income tax, portfolio shareholders of the subsidiary may or may not receive a credit.

3. Property can often be transferred to a branch without triggering current taxation in the home jurisdiction on asset appreciation. Transfers of such property to foreign subsidiaries often give rise to capital gains taxation on any appreciation.

Tax disadvantages of the branch form

1. A multinational enterprise cannot defer home country taxation on branch income not remitted to the home country, in those jurisdictions which tax residents on their global income. By contrast, a subsidiary has the opportunity to defer taxation in the home tax jurisdiction on income which is not remitted. Before 1986, the deferral opportunity enjoyed on the unremitted income of a foreign subsidiary under the U.S. foreign tax credit system favored employment of the subsidiary form by U.S.-based investors with profitable foreign operations.87 Assuming that the host country’s corporate tax rate is lower than the home country’s, incremental tax in the home country is deferred, which reduces the present value of the enterprise’s global tax burden. (This disadvantage to the branch form may no longer be an important consideration for branches operated by U.S.-based parents.) Since the United States’ 1986 tax reform, average tax rates on foreign operations are often higher than the U.S. rate, causing the parent company to earn “excess” or not immediately usable foreign tax credits (except in tax havens). Enterprises based in capital-exporting countries which adhere to the source principle of international income taxation have made greater use of the branch form for foreign operations because most repatriations from either branches or subsidiaries are not taxable.

2. Host tax jurisdictions often provide less generous treatments for loss carryforward and carrybacks to branches than to subsidiaries. Some jurisdictions make no provision in their tax codes for loss carryovers by branches.

3. Limitations on deductions are often more restrictive for branches than for subsidiaries. Such restrictions are usually inspired by the desire to deter transfer-pricing abuses. For example, Switzerland permits subsidiaries but not branches to deduct management fees paid to a head office.88 Such discrimination should be avoided unless the potential for transfer-pricing abuse can be shown to differ across forms of business organizations.

Rationale for a Branch Profits Tax

Many jurisdictions impose a branch profits tax on foreign-based branches to achieve greater neutrality and equity in treatment between branches and subsidiaries and to forestall revenue erosion. Without such a tax, repatriation of branch profits does not give rise to tax liability, unlike the repatriation of dividends by a subsidiary.

A simple branch profits tax at the same or lower rate than the withholding rate on foreign dividends can achieve approximate neutrality between foreign branches and subsidiaries operating in the host country. A lower rate is justified if a branch profits tax is imposed on profits in the year or quarter in which they are earned, whereas the dividend withholding tax is only applied to remittances to shareholders. Countries that impose this form of tax often choose a design which exempts from taxation any income that is rein-vested in the branch. This approach has been adopted under the U.S. 1986 Tax Act.

Some experts advocate that the design should not emphasize internal formal harmonization of the tax system at the expense of administrative simplicity.89 For example, the Canadian branch profits tax, which seeks to achieve rigorous parity between the taxation of subsidiaries and branches, involves the use of concepts which have no counterpart in standard accounting. Developing countries, looking for pragmatic solutions with greatest simplicity, should be able to achieve approximate parity with a simple surcharge on branch profits. For example, in the case of a 40 percent income or enterprise profits tax and a 20 percent withholding tax on distributed dividends, the total tax liability on a subsidiary’s income will be 52 percent, assuming full distribution of income. This example suggests that a 12 percent surcharge on branch profits is appropriate. A somewhat lower surcharge rate is appropriate to recognize the deferral advantage enjoyed by subsidiaries, because such a surcharge would be applied immediately, whereas the withholding tax would apply only upon repatriation; it would also recognize that subsidiaries do not generally repatriate all of their profits.

Instituting a branch profits tax on foreign-based permanent establishments may violate the nondiscrimination provisions of an existing tax treaty. In such cases, current treaties will have to be renegotiated. Introducing such a tax also increases the need to restrict deductible interest disbursements to foreign parties.

Preventing Thin or Hidden Capitalization

Thin or hidden capitalization of a subsidiary arises when a foreign investor responds to tax incentives by substituting foreign debt capital for equity capital financing, particularly in cases where the debt financing exhibits some of the characteristics of equity and the debt is owed to a nonarm’s-length lender. While a high debt/equity ratio per se should not be taken as proof of hidden equity capitalization, a high ratio may indicate efforts to achieve a tax advantage through excessive debt financing. This type of financing enables a foreign-owned subsidiary to reduce its taxable profits by deducting interest payments to nonresident creditors to which only nonresident interest withholding taxes would apply. By contrast, if the profits of a subsidiary are transferred by dividends, such payments will not be deductible in calculating the subsidiary’s taxable profits. In addition, to avoid corporate income taxation on what would otherwise be profits, the thin capitalization strategy may enable the parent company to avoid or defer taxation in the home country.

Multinational enterprises can often use thin capitalization techniques in combination with treaty shopping to reduce their global tax burden, because of different treaty provisions for withholding taxes on dividends and interest. Treaty shopping occurs when a combination of treaty and national tax laws involving more than two countries create a favorable tax regime which can be exploited by residents of nontreaty countries.90 For example, interest payments might be routed through one or more holding companies in a series of countries linked by suitable treaties, so that the return on investment can be shifted from the original source country to a country where it will bear little or no tax.

Thin or hidden capitalization tax rules are designed to restrict such behavior. Three general approaches have been adopted by countries to restrict thin capitalization. These are (1) the denial of a deduction for interest expense on any related party loan; (2) general anti-abuse arm’s-length approach; and (3) acceptable capital-to-debt ratio approach.

The denial approach discriminates in an arbitrary fashion because it penalizes debt between related parties relative to other forms of debt. It also encourages avoidance by disguising related party debt as unrelated debt. Policing such abuse is difficult, particularly for countries with limited administrative resources.

The anti-abuse approach seeks to look behind the form of a transaction, in light of all relevant circumstances, to see whether the real nature of the contribution is debt or equity. Each debt transaction must be examined separately to determine whether the terms of the debt instrument are those which would have been entered into by unrelated parties.

Under the fixed-ratio or capital structure approach, a fraction of interest paid to foreign creditors is disallowed as a deductible expense when the debt/equity ratio exceeds a specified level. The disallowed portion of interest is determined by prorating with the excess debt/equity ratio. In measuring the equity portion of a capital structure, most jurisdictions will find it administratively difficult to insist on the annual fair market valuation of corporate equity. Therefore, a feasible alternative is to define equity as the sum of retained earnings at the beginning of the year, contributed surplus and paid-up capital, though this approach will not be appropriate for jurisdictions with high rates of inflation. The fixed-ratio approach may be applied universally or only to transactions between related parties. Oldman, Rosenbloom, and Youngman advocate that thin capitalization restrictions apply not only in cases of potential outright tax evasion but also to bona fide shifts in capital structure which would transform what would otherwise be dividend payments abroad into deductible foreign disbursements.91 Universal limitation rules should be more effective than rules which permit exemptions and give unnecessary discretion to tax administrators in host countries.

Financial theory and practice suggest that the optimal appropriate ratio of debt to equity varies from industry to industry and from company to company. Countries which employ this approach sometimes provide a higher deductible debt/equity ratio for financial institutions, though this refinement introduces additional administrative complexity.

The ratio approach would appear to be a more appropriate tax instrument for developing countries in combating thin capitalization than the anti-abuse or denial approaches, because of its limited use of tax assessing resources and the lack of administrative discretion.92

Recently, a fourth alternative has been suggested for economies in transition experiencing high rates of inflation. Under this approach, the deduction of interest is limited to a specific percent of taxable income gross of interest expenses, rather than being prorated on the debt/equity ratio. To avoid penalizing financial institutions, a variant of this rule would allow all interest incurred to be deducted up to the amount of interest income. The justification for this approach is to prevent both foreign- and domestic-based enterprises from stripping earnings. This approach may be preferable to the ratio approach when accounting equity cannot readily be modified to reflect inflation-induced changes in fair market value.

Tax Coordination and Harmonization

Angelo G.A. Faria

  • What is the recent experience of tax coordination and harmonization in securing the efficientfunctioning of global trade and capital markets?

AS noted above, the double taxation of foreign-source income by competing tax jurisdictions necessitates unilateral, bilateral, and even multinational schemes of coordination and harmonization with the long-term objective of creating level tax-playing fields for movement of commodities and factors of production and eliminating tax arbitraging of transactions. At a simplistic level, however, it is argued that tax competition through market pressure may be desirable because it brings about spontaneous convergence through downward pressure on taxes, leading to downward pressure on the level of expenditure, greater efficiency in the use of resources by the public sector within countries, and an efficient allocation of the world’s capital. On the other hand, tax competition in this sense is purported to also have destabilizing shorter-term macroeconomic spill-over effects, which interfere with the efficient functioning of global trade and capital markets. As previously indicated, the optimal condition for efficiency is a residence-based approach to international taxation by all countries. In practice, however, tax competition occurs through terms-of-trade manipulation among countries arising from the incidence of taxes on the intratemporal terms of trade (the relative price of goods) and the intertemporal terms of trade (the interest rate).93

It is suggested that the three major criteria for inter-jurisdictional tax coordination are interjurisdictional equity, locational neutrality, and taxpayer equity. According to these principles, source countries have the primary right to tax income earned within their territories, while domicile countries should assume responsibility for achieving local neutrality and taxpayer equity, usually by applying the residence principle to tax foreign source income and allowing foreign tax credits. Interjurisdictional equity is achieved by having full reciprocal uniformity in corporate and withholding tax rates among countries. In practice, however, these clear-cut principles seldom hold, and thus efforts continue to be made at best to avoid beggar-my-neighbor tax competition through bilateral coordination arrangements.

There is more than a mere semantic difference, particularly in relation to developed and developing countries, between tax coordination (TC) and tax harmonization (TH). From a substantive perspective, TC can be viewed as a process leading up to the ideal TH. TC may, as noted above, be unilateral or cooperative in dimension. It does not imply uniformity of individual taxes between countries, much less uniformity of their tax systems. Indeed, one may strictly view any adaptation of a domicile country’s tax system to that of a source country and vice versa as representing TC, if the objective is not to increase the overall tax burden. On the other hand, tax harmonization in some sense presupposes the process of establishing a wider regional economic grouping which may be based on factors other than comparable economic strength such as geographical proximity. Attempts have been made, usually at the regional level, and in the context of established free trade unions or common markets, to move toward TH. Examples include: Central American Common Market (CACM) in 1958, Latin American Free Trade Association (LAFTA) in 1961, Council of Arab Economic Unity (CAEU) in 1961, Central African Customs and Economic Union (UDEAC) in 1964, Andean Subregional Integration Agreement (ASIA) in 1969, Caribbean Community (CARICOM) in 1973, Economic Community of West African States (ECOWAS) in 1975, and Latin American Integration Association (LAIA) in 1980. The most well known of these is, of course, the European Community (EC) established in 1975 and still in progress. More recently, strenuous attempts are being made to establish a North American Free Trade Area (NAFTA).

The experience with regional tax harmonization has been only modestly encouraging. Some success has been recorded in establishing a common external tariff and equalizing interest taxes, against which there has been negligible progress in achieving interjurisdictional equity in taxing appropriate income shares. In the EC, the view remains that tax harmonization should proceed in a stepwise fashion beginning with agreement on the type of tax to be harmonized, followed by harmonization of the tax base, and eventually by harmonization of the tax rates. On this basis, the harmonization process has been restricted to a few major taxes: turnover taxes, excise duties, corporation taxes, withholding taxes on dividends and interest, and some capital duties. In this respect, major progress has been made only in harmonizing VAT regimes across member countries, and even this is not fully for tax rates.

In harmonizing taxes, it is suggested that the objective should be to permit intercountry diversity reflecting national preferences, consistent with minimizing the net burden of benefits and costs of government intervention. This is a broader view than straightforward tax uniformity because it implies that efforts at tax harmonization or uniformity must also take account of the expenditure side of the budget. Moreover, enough recognition has not been given to the fact that even formal tax harmonization seldom equates with effective tax harmonization because of variable country performance in administering taxes. With the marked increase in multinational trading ventures, some form of tax coordination or selective tax harmonization seems unavoidable to ensure taxpayer equity and neutrality that developed countries find important, as well as greater revenue and investment flows that are the primary concern of developing countries.

Consumption Taxes

In tax relations between developed countries, coordination and even harmonization of consumption taxes has recorded relatively greater success than that of income taxes. This is probably because with such taxes entering into traded goods prices, their distorting effects on trade flows are more immediate and visible, and the search for solutions becomes more urgent. Thus, adaptations—unilaterally in some cases—have been made to import tariffs, export taxes, and VATs based on some evolving consensus of their purpose and the structures of their bases and rates. But troublesome problems of border tax adjustments continue to manifest themselves in this process.

In the VAT area, the general trend to consumption-type, destination-based, and tax-crediting taxes seems well established. It has been recognized that an excess tax burden on tradables is created directly when the nominal tax rate for imports is higher than that on similar domestically produced goods, or when domestic tax incorporated in the export price is not fully rebated at the export stage through prompt border tax adjustments. Within the EC, it has proved easier, in relation to the VAT, to agree on the nature of the tax (consumption type) and the tax base (virtually all domestic consumption of goods and services except financial services) than the tax rate structure (number and levels of rates, although the 6th Directive has formalized a minimum rate level of 15 percent). Clearly, having the uniformity of a single rate would be desirable, as open national borders within the EC came into effect in 1993 (see the section on VAT, Chapter III).

The movement to regional economic groupings involving a common market with a common external tariff has underlined the changing primary role of the import tariff. With the development of economies and associated tax structures in developing countries, the import tariff is viewed less as a revenue “tax handle” and more as an instrument of effective protection of domestic production. This has increasingly resulted, in such countries, in simplified tariff structures with fewer nominal rates differentiated by degree of industrial processing, and lower average rates. On the export side, while zero rating of industrial exports has generally been accepted, taxation of primary and universal agricultural exports still continues. Particularly in countries that, although producers of a single good, individually have only a small world market share and thus cannot influence world prices. As such, they face difficulty in shifting production-based taxes forward into final export prices.

As one would expect, because of their essentially revenue, country-specific nature, there has been little cross-country harmonization of excise duties even for commonly taxed sumptuary products. Some attempt, however, has been made to harmonize them within countries, through an equivalence or level playing field in the overall tax burden applicable to similar imported and domestically produced goods.

Income Taxes

The harmonization of cross-country income taxes has evoked much analysis because of its implications for global capital flows, business savings, choice of investment and, in developing countries, revenue yield. Particular attention has been focused on the after-tax return to capital, that is, the net return after the combined rate of tax applicable to corporate profits and withholding on capital income, because of its consequences for capital import neutrality.

Considerations of interjurisdictional equity—brought to the fore by the principle that a source country should have a prior tax claim of income arising within its jurisdiction—have raised questions about how its tax base and tax rate should be determined by tax administrations in relation to claims made by competing tax jurisdictions or countries. Ideally, the division of the tax base should be determined through a “separate accounting” approach under which, using traditional accounting methods and assuming “arm’s-length” pricing, the income of, say, multinational trading firms is assigned between the different countries in which operations are carried out through a permanent establishment. Such determinations may, and generally are, at variance with those made by firms themselves. Thus, while recognizing interfirm or intergroup linkages, notably relating to shared overheads and scale economies, the principal difficulty for tax administrations, especially those in developing countries, is how to challenge foreign or multinational firms’ manipulation of profits across tax jurisdictions to minimize their tax burdens through transfer-pricing, royalty agreements.

As regards the tax rate applicable to an assigned tax base, in practice, the main difference has related to the treatment of capital profits and capital income arising from the ownership and sales of physical and financial assets. For capital profits, the prevailing practice is one based on the principle of nondiscrimination between profits accruing to nonresidents and those accruing to residents. It has been suggested, however, that the nondiscrimination rule may not be appropriate because the tax rate applicable to nonresident income should be decided more on grounds of interjurisdictional equity, while the rate for resident income should be based more on domestic economic policy and revenue considerations.94 Where considerations of revenue conflict with those of interjurisdictional equity, then a rule of reciprocity is applicable, generally in the framework of bilateral tax treaties. Under this rule, which has earned widespread acceptance, common forms of capital income (e.g., dividends and interest) are made subject to final withholding taxes at similar rates in the source and domicile countries. This attempt to balance reciprocity and interjurisdictional equity has under-standably not found much favor with developing countries as source countries because most such income is then repatriated to the domicile country where it can be taxed at a higher corporate rate.

The tax treatment of corporate profits and distributions between a source country and a domicile country is further complicated when they operate the classical system or full/partial integration or imputation schemes. In principle, and based on interjurisdictional equity grounds, the source country is not really involved, so that it ultimately becomes an issue of how much revenue the residence country is residually prepared to trade off permanently or temporarily (through tax deferral) for tax equity or tax neutrality, or both, or even whether it wishes thereby to make explicit provision of a tax preference to investment in the source country. In practice, of course, considerations of revenue gain have to be tempered by implications for foreign investment, for source countries. For domicile countries, the consequences of its tax treatment of CEN remain a major cause for concern. Clearly, compromises relating to these different, perhaps competing, sets of considerations are best secured and sustained through tax harmonization in the form of bilateral double taxation treaties or similar arrangements in wider geographical groupings.


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For a more detailed analysis and statistical data, see International Monetary Fund (1993).


Successiverounds of multilateral trade negotiations reduced average tariffs for manufactured goods among industrial countries from 40 percent in the period immediately following World War II to 5 percent after the Tokyo round in 1979. Most of this reduction took place in the early years of the postwar period.


For analyses of recent developments in international trade policies, see Kelly and McGuirk (1992), Bhagwati (1988), World Bank (1987), Corden (1987), International Monetary Fund (1993), and Kelly et al. (1988).


For a comprehensive exposition, see Corden (1974) and Dixit (1985).


For an overview of the links between outward-oriented trade strategies and economic growth, see International Monetary Fund (1993), Chapter VI.


For exposition and review of the political dimension of protectionist policies, see Krueger (1974) and Bhagwati (1982).


A standard presentation of the argument behind the superiority of domestic taxation can be found in Dixit (1985).


There is abundant empirical evidence that supports the view that higher marginal social cost accompanies trade taxation. For a selection of recent references and case studies, see World Bank (1988) and Tanzi (1990).


For recent analyses and descriptions of the use of antidumping and countervailing measures, see Bhagwati (1988) and Kelly et al. (1992).


See, for example, Helpman and Krugman (1989).


See Bhagwati (1988).


Further evidence in the same direction can also be found in Kelly and McGuirk (1992).


Arguments in this direction can be found in Baldwin (1990 and 1992).


Some of the most influential presentations of the theory of strategic trade and the new international economics are Grossman and Richardson (1985), Krugman (1986, 1987a, and 1987b), and Helpman and Krugman (1985). Critical appraisals can be found in Harberger (1990) and Baldwin (1992), among others.


See Harberger (1990).


Domestic price means the price prevailing in the domestic market. Notice that this price might be, in some cases, below the level given by the international price plus the tariff (prohibitive tariffs). This will be the case if perfect or monopolistic competition prevails in domestic markets and the tariff is set at a level such that the international price plus the tariff is above domestic average costs. It could also occur under monopolistic or oligopolistic conditions if the price that results from these conditions is below the international price plus the tariff.


For example, a country might impose a tariff on cars even if there is no domestic production. In that case, an excise would yield the same revenue and would not afford protection to future or prospective domestic producers.


If there is imperfect competition, for example, when a country has monopsonistic power on the market for some imported commodity, the imposition of a tariff may lower its international price. In extreme cases, the domestic price could even decrease after the imposition of a tariff (the Metzler paradox). The analysis developed in this section abstracts from such effects.


Value added in an industry or total value of production can be used to compute the weights.


For a survey on empirical studies and measures of protection, see Krueger (1984).


For an extensive coverage of the issue of optimal tariffs in the context of adjustment policies, see Subramanian, Ibrahim, and Torres-Castro (1993).


The superiority of domestic taxation over international trade taxes is examined in the other sections. (See the arguments for and against tariffs in the section on trade and protectionism.) An exposition of the suboptimality of tariffs vis-à-vis domestic taxation can be found in Dixit (1985).


Formal derivations of this result can be found in Auerbach (1985) and in Atkinson and Stiglitz (1980). The rationale behind it is that when the tariff rate is low, the first resources that are shifted to less efficient uses are those that exhibit similar productivity in their new and old functions. Therefore, the misallocation of resources has a comparatively low cost. In contrast, when the tariff rate is high, it can cause reallocation of resources to uses where their productivity is much lower than in their optimal employment.


World Bank (1988) contains estimates of the economic cost of tariffs for several countries.


A uniform rate tariff accords equal effective protection to all import-substituting industries. Exports, however, are penalized and have a negative effective protection rate in the absence of duty drawbacks. Similarly, producers of nontradables will experience a decrease of the relative price of their output. Therefore, resources will be shifted from export-oriented and other industries to import-substituting industries. This anti-export bias is an instance of the efficiency losses introduced by a tariff.


For a defense of a uniform tariff rate on political economy grounds, as well as a discussion of advantages and shortcomings of rate differentiation, see Harberger (1990).


Fora contemporary treatment of the theory of optimal taxation, see Atkinson and Stiglitz (1980) and Auerbach (1985). Applications of the theory of optimal taxation to the topic of optimal tariff structures can be found in Dasgupta and Stiglitz (1974), and Corden (1974).


Considerations stemming from the theory of optimal taxation, however, could provide arguments in favor of tariffs on “demerit” goods—such as alcoholic beverages, tobacco products, etc. Although in these cases, a domestic excise is superior to a tariff, the latter may be the only feasible option owing to constraints on available tax handles. Thus, the rationale for excises may extend to tariffs on selected items under some circumstances.


See this chapter’s section on free trade and protectionism.


That is, the size of the tariff would be inversely related to the elasticity of supply faced by the country.


Notice that the price of domestically produced importable inputs will also increase as a result of the protection accorded against competing imported inputs. Similarly, exportables sold in the domestic market will not be able to command a price higher than their international price if they are actually exported in any amount. As soon as the domestic price of exportables deviates upward from their international price, production destined to export markets will be redirected to the domestic market depressing their price. This process will continue until the domestic price is driven down to the level of the international price or until the goods are no longer exported.


More recently, and in the context of transitional economies, Estonia has also applied a policy of virtual free trade. As a result of this policy, inter alia, the reorientation of trade toward Western Europe has been extremely successful.


For an exposition and assessment of a variety of export-promoting strategies, see Thomas and Nash (1991).


See Panagariya (1992).


Some of these countries have announced their intention to repeal or phase out export taxes in the future.


Sanchez-Ugarte and Modi (1987) and Gomez-Sabaini (1990) contain case studies and an empirical assessment of whether the role played by export taxes has been in agreement with their declared goals.


Here, and in the rest of this section, the exchange rate is the price of one unit of domestic currency in terms of a foreign currency. Correspondingly, the exchange rate is overvalued if the price of the domestic currency is higher than the relevant standard—given, for example, by the market-clearing exchange rate or by the purchasing power parity.


See Sanchez-Ugarte and Modi (1987).


See, for example, Bhagwati (1988).


The origin and destination principles are discussed in Chapter III.


Transactions taxes on currency conversions may also influence capital flows (see Tobin (1978)).


See OECD (1979). The arm’s-length standard is also recognized in Article 9 of the OECD model tax convention. See OECD (1992).


See OECD (1979), p. 33.


See OECD (1979), pp. 42–43.


See Alworth (1988), p. 223.


See Hufbauer (1992), pp. 108–09.


See Kopits (1976), p. 86.


See Bernard and Weiner (1990), pp. 123–60.


For example, as of 1992, a number of developing countries including India, Bangladesh, Malawi, Sri Lanka, and Zimbabwe retain company or business profits tax rates above 40 percent. See Bagchi (1991), p. 45.


The studies are the 1981 General Accounting Office report and the 1984 and 1987 Internal Revenue Service surveys cited in U.S. Department of the Treasury (1988); and in Hufbauer (1992), pp. 111–12.


See Daly (1992), p. 1073.


For example, in Jamaica, a production levy is imposed on bauxite producers which is based on a fixed percentage of the price at which aluminum ingots are sold on the open market in the United States.


See Conrad (1991), pp. 727–47.


See OECD (1992), pp. M 10–11.


This tax-motivated incentive for U.S.-based foreign investors to adopt the subsidiary form has been lessened by the changes arising from the 1986 U.S. tax reform. See Ault and Bradford (1990).


See Hufbauer (1992), p. 218; and OECD (1987), p. 11.


See Oldman, Rosenbloom, and Youngman (1992), p. 395.


For example, see recommendations on thin capitalization in Oldman, Rosenbloom, and Youngman (1992), pp. 385–98.